Report No. P7441-ET

Document ofThe World Bank

FOR OFFICIAL USE ONLY

REPORT AND RECOMMENDATION

OF THE

PRESIDENT OF THE

INTERNATIONAL DEVELOPMENT ASSOCIATION

TO THE

EXECUTIVE DIRECTORS

ONA

PROPOSED CREDIT

OF SDR 116.6 MILLION (US$150 MILLION EQUIVALENT)

TO

THE FEDERAL DEMOCRATIC REPUBLIC OF ETHIOPIA

FOR AN

ECONOMIC REHABILITATION SUPPORT CREDIT

April 30, 2001

This document has a restricted distribution and may be used by recipients only in the performance oftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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GOVERNM FISCAL YEAR: JULY 8 - JULY 7

Currency EquivalentCurncy Unit = Ethiopian Birr

Market mid-rate: US$1.00 = 8.267 (April 10, 2001)

ABBREVIATIONS AND ACRONYMS

ADLI Agricultural Development-Led IndusttializationAIDS Acquired Immune Deficiency SyndromeCAS Country Assistance StrategyCBE Commercial Bank of EthiopiaCPPR Country Portfolio Performance ReviewCSRP Civil Service Reform ProgramDBE Development Bank of EthiopiaEDRP Emergency Demobilization and Reintegration ProjectEIA Ethiopian Investment AuthorityEIP Extension Intervention ProgramEMCP Expenditure Management and Control ProgammEPA Ethiopian Privatization AgencyERSC Economic Rehabilitation Support CreditEU European UnionFAG Federal Auditor GeneralFCSC Federal Civil Service CommissionFIAS Foreign Investment Advisory ServiceFMIS Financial Management Information SystemFY Fiscal YearGDP Gross Domestic ProductHIPC Heavily Indebted Poor CountriesHIV Human Imnuno-deficiency VirusHRM Human Resource ManagementHRMIS Human Resource Management Information SystemIDA International Development AgencylFC International Finance CorporationIMP International Monetary Fund1PF Indicative Planning FiguresI-PRSP Interim Poverty Reduction Strategy PaperIT Information TechnologyJCG Job Classification and GradingMEDaC Ministry for Economic Development and CooperationMEFF Macroeconomic and Fiscal FrameworkMoF Ministry of FinanceNBE National Bank of EthiopiaNDP National Development ProgramNGO Non Governmental OrganizationNPV Net Present ValueNYCE New York Commodity ExchangePEP Public Expenditure ProgramPER Public Expenditure ReviewPIP Public Investment ProgramPMO Prime Minister's OfficePPI Private Participation in InfiastructurePRGF Poverty Reduction and Growth FacihtyPRSP Poverty Reduction Strategy PaperSAC Structural Adjustment CreditSOE State Owned EnterpriseUN United NationsUSAI) United States Agency for Intemational DevelopmentWMS Welfare Monitoring SystemWAN Wide Area Network

Vice President: Callisto MadavoCountry Director: Oey Astra MeesookTechnical Manager: Fred KilbyTask Team Leader: Miria Pigato

FOR OFFICIAL USE ONLY

THE FEDERAL DEMOCRATIC REPUBLIC OF ETHIOPIAECONOMIC REHABILITATION SUPPORT CREDIT

CONTENTS

L. POLITICAL, SOCIAL AND ECONOMIC CONTEXT .............................................. 3

A. POLITICAL CONTEXT ..................................................... . 3B. ECONoMIC AND SOCIAL PERFORMANCE .5........... ...... 5

IL THE GOVERNMENT'S ECONOMIC AND SOCIAL PROGRAM. 8

A. OVERVIEW AND KEY GOVERNMENT OBJECTIVES .................. .... 8B. THE MACROECONOMIC FRAMEWORK .................................................. 8............. .. 8C. THE GOVERNMENT'S MEDIUM-TERM REFORM PROGRAM .. ......... 12D. PUBLIC SECTOR MANAGEMENT ....... 13E. PUBLIC EXPENDITURE POLICY AND MANAGEMENT ......... 16F. PRIVATE SECTOR DEVELOPMENT AND EXPORT COMPETITIVENESS ........ 20

L THE PROPOSED CREDIT ...................... 24

A. CREDIT RATIONALE AND COMPONENTS .................... 24B. CREDIT AMOUNT AND TRANCHING.2.5..... .... ........... 25C. SUMMARY OF FIDUCIARY ARRANGEMENTS .............. 25D. REFORMS SUPPORTED BY THE ERSC ... ..... . 25E. IMPLEMENTATION ARRANGEMENTS ................ ....... 26F. RISKS .................. 2................... 27

V. RECOMMENDATION .27

ANNEXES

Annex A: Policy MatrixAnnex B: Letter of Development PolicyAnnex C: Country at a GlanceAnnex D: Key Economnic IndicatorsAnnex E Key Exposure IndicatorsAnnex F: Balance of Payments, 1997-2003Annex G: Social IndicatorsAnnex H: Status of Bank Group OperationsAnnex I: Portfolio Improvement and Project Implementation

This operation was prepared by a team consisting of Miria Pigato (AFTM2, Task Team Leader), Christiane Kraus, WilliamJames Smith, Duvvuri Subbarao (AFTM2), Amar J. S. Sodhi (AFTR2), Navin Girishankar (AFTI), Vinaya Swaroop(DECRG), and Andrew Singer (consultant). Peer reviewers were Rocio Castro (AFTM4) and Milan Brahmbhatt (PREMEP).Fred Kilby, Sector Manager (AFTM2) and Oey Astra Meesook, Country Director (AFC06), provided guidance.

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not be otherwise disclosed withoutWorld Bank authorization.

FEDERAL DEMOCRATIC REPUBLIC OF ETHIOPIAECONOMIC REHABILITATION SUPPORT CREDIT

CONTENTS (cont'd)

FIGURES

Figure 1: Trends in Coffee Export Volumes and Prices, 1992/93-2000/01Figure 2: Terms of Trade Index, 1992/93-2000/01Figure 3: Defense Spending as Share in Total Public Expenditure and GDP

TABLES

Table 1: Ethiopia: Key Macroeconomic Indicators, 1995/96-1999/2000Table 2: Ethiopia: Projected Macroeconomic Indicators, 2000/01-2002/03Table 3: Financing Requirements and Sources, 2000/01-2002/03Table 4: Ethiopia. General Government Poverty-Targeted and HIPC Relief-

Related Expenditure (in percent of GDP)

BOXES

Box 1: Ethiopia's PRGF ProgramBox 2: The Impact of High Oil and Low Coffee Prices on the Balance of Payments and

Fiscal Accounts

FEDERAL DEMOCRATIC REPUBLIC OF ETHIOPIAECONOMIC REHABILITATION SUPPORT CREDIT

SUMMARY

Beneficiary: THE FEDERAL DEMOCRATIC REPUBLIC OF ETHIOPIA

Project Task ID: PE-P072890-LEN

Implementing Agency: Ministry of Finance

IDA Amount: SDR 116.6 million (US$150 million equivalent)

Terms: Standard IDA terms: 40 years maturity with a 10-year grace period

Disbursement: The proposed Credit will be disbursed on effectiveness through theNational Bank of Ethiopia.

Description: The proposed Credit provides initial support for the Government'sefforts in stabilizing the economy and moving back to a sustainablepath of growth. It helps restoring key economic and social services andinstitutional capacity, while financing increased private sector importsassociated with the removal of restrictions in the foreign exchangemarket. It supports the Government's program to improvemacroeconomic performance and reallocate public spending to poverty-targeted sectors; and it addresses the Government's reform agenda inthree priority areas: (i) public sector management; (ii) publicexpenditure policy and management; and (iii) private sectordevelopment and export competitiveness.

Benefits: Within a context of peace and macroeconomic stability, the proposedCredit will help to bring about a sustained economic recovery and areduction in poverty. Public sector management and expenditurestrengthening will increase administrative efficiency and improve thedelivery of public services. Private sector reforms will spur growth andcreate employment opportunities for the poor, particularly inagriculture and in the export sectors.

Risks: The proposed Credit faces four categories of risks: First is thepossibility of resumption of hostilities with Eritrea. This risk is reducedby the deployment of UN peace-keeping troops which monitor theimplementation of the peace agreement; the creation of a borderTemporary Security Zone, from which Ethiopia and Eritrea havewithdrawn their troops; and the demobilization of the army, which isproceeding at a faster rate than anticipated. In addition, for the currentyear the Government anticipates a further reduction of defensespending over the budgeted amount. Second, the economy is vulnerableto external shocks such as a drought or unfavorable terms-of-trademovements. However, the potential availability of finance fromdevelopment partners could provide an additional cushion againstexternal shocks if needed. Third, there is a significant risk of delays inthe implementation of the reform program because of weak institutionalcapacity in both the public and private sectors. This risk could be

I

reduced by the financial and technical assistance provided by the donc,rcommunity. The Govemment has also asked for an increase in IDAassistance specifically in the area of capacity building. Finally, there i sa risk of weakening govemment commitment. So far, the Governmenthas shown its strong commitment to the reform program byimplementing a number of reform actions in anticipation of the ERSCand by parallel efforts to strengthen public expenditure management toimprove monetary management and continue the financial sectorreform.

2

REPORT AND RECOMMENDATION OF THE PRESIDENTOF THE INTERNATIONAL DEVELOPMENT ASSOCIATION

TO THE EXECUTIVE DIRECTORS ON A PROPOSEDECONOMIC REHABILITATION SUPPORT CREDIT

OF SDR 116.6 MILLION (US$150 MILLION EQUIVALENT)TO THE FEDERAL DEMOCRATIC REPUBLIC OF ETHIOPIA

1. I submit for your approval the Report and Recommendation on a proposed EconomicRehabilitation Support Credit (ERSC) to the Federal Democratic Republic of Ethiopia in theamount of SDR1 16.6 million (US$150 million equivalent). The operation is part of an assistanceprogram to address the country's immediate post-war recovery needs. The IDA Board endorsedthe program, set out in the Interim Support Strategy (Report No. 21189 ET), on December 5,2000. The ERSC provides essential financing to enable the recovery of the post-conflictEthiopian economy. It also supports the implementation of key actions of a reform programformulated in the Interim Poverty Reduction Strategy Paper (I-PRSP). Specific measures aim at:(i) improving governance through cross-cutting public sector reforms; (ii) strengthening publicexpenditure policy and management; (iii) fostering private sector development and increasingexport competitiveness. The main elements of the reforms supported by the proposed Credit arearticulated in the attached Letter of Development Policy. The reform program is supported by theIMF through a PRGF arrangement.

I. POLITICAL, SOCIAL AND ECONOMIC CONTEXT

A. POLITICAL CONTEXT

2. Settling into Peace. On December 12, 2000, Ethiopia and Eritrea signed a peaceagreement, thereby ending an armed conflict that had begun in May 1998 and lasted for morethan two years. On February 6, 2001, they agreed to a 25 mile Temporary Security Zone fromwhich Ethiopia and Eritrea have withdrawn their troops. A U.N. force of about 4,200peacekeeping troops, the United Nations Mission in Ethiopia and Eritrea, is patrolling the bufferzone, monitoring the implementation of the peace agreement, supporting efforts to demobilize thearmy, and accommodating the return of displaced civilians in both countries.

3. Recent Developments. The current Govemrnent - a coalition led by the EthiopianPeople's Revolutionary Democratic Front - came to power in 1991, after a struggle that endedyears of civil war. The ruling party was reconfirmed in the national elections held in May 2000.Following the recent peace agreement, the Government has initiated the demobilization of thearmy, and the reconstruction of damaged infrastructure and the rehabilitation of key publicservices. The war has had a significant human and economic impact. Some 36,000 civilians andmembers of the militia died and many of their families are now on the verge of destitution. About364,000 people were displaced and half of them still cannot return to their homes, owing to thepresence of landmines, or because essential infrastructure was damaged or destroyed.Additionally, there are 110,000 persons of Ethiopian origin who had been residing in Eritrea andhave returned from there as a result of the war, most of them depending on state support. Anotherarea of concern is the increased risk of WV/AIDS transmission in the army and in thecommunities affected by the war.

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4. The impact of the war has been heavy on private sector development and investorconfidence, resulting in a sharp fall in new investment during 1999-2000. At the same time, theGovermment has been dealing with the consequences of a severe drought which, combined witlIinadequate transport and marketing infrastructure, has increased food vulnerability for manyEthiopians. Additionally, a strong decline in the price and output of the country's main exportcommodity - coffee - and a simultaneous surge in the price of oil (see paragraphs 17-18) haveworsened the country's extemal position.

5. In the second half of 2000, following the cessation of hostilities with Eritrea, theGovernment resumed its reform efforts. Following consultations within various levels of ttLeadministration, private sector organizations and donors, it prepared a comprehensive I-PRS]'1.The strategy re-affirms the Government's commitment to poverty reduction, within a framewor kof macroeconomic stability. It aims at achieving equitable growth through addressing theimmediate reconstruction and reintegration needs, raising the incomes of the rural poor, andimproving the delivery of public services, as well as social indicators. The macroeconomicframework underlying the I-PRSP was discussed with Fund and IDA staffs and a PovertyReduction and Growth Facility (PRGF) was approved by the IMF Board on March 19, 2001.

6. International Response. Since the cessation of hostilities in June 2000, the internationalcommunity has provided Ethiopia with political, humanitarian and post-war restructuring support.The Organization of African Unity, the UN, the United States and the European Union haxiehelped to mediate in the peace negotiations. In support of the Government's request in January2000 for assistance to the intemally displaced, the UN issued an appeal and relief action planunder which the World Food Program has been providing assistance to over 200,000 peopledisplaced by the conflict. Response to the drought emergency was coordinated and managed byUSAID' s Office of Foreign Disaster Assistance in close cooperation with the EthiopianGovemment.

7. IDA Response and Strategy. IDA's support strategy for Ethiopia is described in thleInterim Support Strategy (December 2000). Up to US$700 million would be provided in newcredits over the subsequent 12 to 24 months to address the impact of the conflict. The strategycenters around three key objectives. They are: (i) addressing the immediate human, infrastructureand economic emergency, and setting the economy back on the path of sustainable growth; (:i)tackling weaknesses in the management of the IDA portfolio; and (iii) initiating long-term Bar.kassistance in three areas of key structural importance, namely food security, HIV/AIDS, andcapacity building for the delivery of essential services'.

8. The Economic Rehabilitation Support Credit. In the Interim Support Strategy, it wasanticipated that balance of payment support of US$250 million would be needed from IDA tosupport the overall macroeconomic framework during 2000/01 and 2001/02. The proposed Creditof US$150 million equivalent covers the immediate financing requirements for the present fiscalyear. The ERSC is structured as a single tranche rehabilitation credit for a number of reasons.First, this instrument is better designed to meet the urgent financing needs of an economy that istrying to recover from a war, as well as to deal with the impact of a drought and of a terms of

l The strategy includes four operations: a) The Emergency Demobilization and Reintegration Project (EDRP -- US$170.6 million),which became effective on February 22, 2001. The project finances demobilization and return of the veterans to their communit ns;economic reintegration assistance, medical rehabilitation for disabled veterans; and HIV/AIDS education; b) The EmergercyRecovery Program (ERP- US$230 million) which became effective on February 15, 2001. The project includes: the de-mining of lheborder areas; resettlement packages for internally displaced persons and deportees; and the reconstruction of private housing ;mdpublic/social infrastructure; c) The Fertilizer Supplemental Credit (IDA US$44 million) aimed at providing an adequate supply offertilizers; and d) The Emergency Support Credit, which is discussed in this Report and now re-named the Economic RehabilitationSupport Credit (IDA USI 50 million equivalent).

4

trade decline. Subsequent operations would be designed to reflect changing circumstances andthe specific financing requirements at that point in time. Second, the Government is firmlycommitted to the overall reform program, even though in several areas, notably civil servicereform and public expenditure management, some actions require elaboration in the context ofaction plans that are in the process of being developed. Finally, the Government is preparing thePRSP, and plans to consult extensively with stakeholders. In this context, detailed discussion ofthe specific actions that a follow-on credit might support will take place during the formulation ofthe PRSP.

9. The ERSC is intended to serve as a bridge to a number of policy-based follow-onoperations that will support the Government's medium-term poverty reduction strategy. The mainelements of the medium-term reform program, which the Government is committed to specify inmore detail in the context of the PRSP, are described in the Policy Matrix (Annex A). The Matrixalso indicates key measures already implemented or agreed with the Government in the context ofthe ERSC; a number of policy measures to be implemented in the next six months, beforedetailed discussions of a follow-on operation would start; and actions that the Governmentintends to take within the next two years.

10. The outline of the Report is as follows. The remaining sections of Part I describeEthiopia's recent social and economic performance. Part II discusses the Govemment's medium-term economic and social program. It presents not only the specific measures supported by theERSC but also suggests reform actions that the Government would take in the next six months,before a possible follow on operation, and the broad agreements reached on measures that theGovemment would implement during the remaining of the fiscal year 2001/02 and during2002/03. Part III discusses the specific details - credit rationale and amount, actionsimplemented prior to Board presentation and implementation arrangements - of the ERSC. PartIV presents the recommendation of the President.

B. ECONoMIc AND SOCIAL PERFORMANCE

11. Macroeconomic performance improved in the 1990s. At the beginning of the 1990sEthiopia had lower income levels than in the 1960s, high inflation rates and unsustainable fiscaland external balances. In 1992, the new government began to implement a far-reaching programof economic reforms with the support of an IDA structural adjustment credit (SAC) as well asIMF programs. Reforms included: a 60 percent devaluation of the Ethiopian birr; the abolition ofprice controls and the removal of many barriers to competition; the introduction of a retail foreignexchange auction system; the streamlining and reduction of import tariffs; and initial steps toprivatize public sector enterprises and to liberalize the financial sector. A new Constitution -approved in 1994 - established a democratic, federal and decentralized system of Government, asignificant change from the centralization model pursued under Emperor Haile Selassie I and theDerg regime.

12. Adherence to the program of stabilization resulted in a recovery of economic growth andin a decline in the inflation rate. Both external and internal imbalances were also significantlyreduced. A further improvement in macroeconomic performance was achieved during the period1995/96-1997/98 despite a terms of trade deterioration in 1996 and a drought in 1997. Overallprogress in macroeconomic stabilization, coupled with a sharp reduction in defense spending,enabled the government to redirect spending towards infrastructure and social programs.

5

Table 1: Ethiopia: Key Macroeconomic Indicators, 1995/96-1999/2000Fiscalyears 1995/96 1996/97 1997/98 1998/99 1999/2000

(annual percent change)Real GDP 10.6 5.2 -1.4 6.2 4.6Consumerprices(annualaverage) 0.9 -6.4 3.6 3.9 4.2Termsoftrade(decline= -) -24.1 10.5 18.1 -14.4 -21.9Real effective exchange rate -8.2 1.2 -0.9 -1.0

(in percent of GDP)Overall fiscal balance (incl. grants) -5.6 -2.4 4.3 -8.5 -11.6Total expenditure 26.9 24.2 25.2 30.0 32.7

- defense 2.0 2.0 4.9 8.7 13.3- poverty -targeted 10.8 8.6

Gross domestic savings 7.0 7.9 5.7 -0.1 4.7Gross domestic investment 16.9 17.0 15.1 14.8 12.3External current account (incl. official 1.1 -3.0 -1.6 -7.9 -7.5transfers)Gross official reserves (in months of imports) 7.7 4.4 3.0 2.8 2.0External debt* /GDP 151.0 79.9 78.4 82.8 86.5Debt service ratio ** 36.8 84.1 57.7 63.3 53.4

Source: Ethiopian authorities, and st estimates.*Before 1999/2000, after debt relief; thereafter, before debt relief**IIn percent of exports of goods and non factor services

13. Poverty was reduced. After three decades of declining living standards, rural incomesincreased during 1991/92-1996/97. Also, evidence from Household Budget Surveys suggests thatthe number of poor people (living on less than half a dollar per day) declined by 16 percenitbetween 1985 and 1995. This improvement was the result of structural reforms, and of newGovernment programs to directly address rural poverty. Particularly noteworthy were theliberalization of rural product and factor markets, the termination of the compulsory labc'rrequirement on collective farms, and the lifting of the ban on wage labor. The shift of pubi'tcexpenditures towards roads, health and education, and away from defense expenditures (until thewar with Eritrea) and the implementation of a strong agricultural extension program, thatpromoted the use of a package of inputs (fertilizers, improved seeds and husbandry, pesticides,backed by extension and credit) also contributed to the improvement in rural incomes. However,while poverty may have decreased in the early 90s, Ethiopia remained one of the poorestcountries in the world, with a per capita GDP of about US$1002. In 1995/96, over 45 percent ofthe population lived in poverty, and 24 percent in extreme poverty.

14. Vulnerability increased during the late 1990s. The impact of repeated droughts, thespread of the HIV/AIDS epidemic and, more recently, the dislocations, infrastructure destructionand decline in funding to social services due to the war have temporarily reversed some of thepast gains and increased the vulnerability of the poorest, particularly in rural areas. Ethiopia ranks171 (out of 174 countries) in terms of the UN Human Development Index. Life expectancy hasdeclined to 43 years. More than two thirds of children are showing signs of stunting, a rate higherthan elsewhere in the region. Literacy rates of 27 percent are very low, with large gender aidurban-rural gaps prevailing. However, the refocus of Government programs on primary educati,.nand health care in the early 1990s resulted in an increase of the gross primary enrollment ratefrom 29 percent in 1994 to 43 percent in 1998, and in an increase in the use of health facilities bythe poor. In preparation of the forthcoming PRSP, the Government is undertaking a detailedanalysis of poverty on the basis of the recent 1999/2000 household consumption and expendittiresurvey, and will review the poverty impact of major sectoral policies and programs.

2 See World Bank "Ethiopia: Poverty and Policies for the New Millennium", 1999, Report no. 19804-ET

6

15. Ethiopia hosts the third largest number of people with AIDS in the world(afterSouth Africa and India). Over 9 percent of the Ethiopian adult population (3.2 million) is nowliving with HIV/AIDS. The 650,000 AIDS orphans in Ethiopia are estimated to be the largestnumber worldwide. Unless the epidemic is slowed, much of Ethiopia's economic developmentefforts will be undermined, and its social fabric compromised. To address this issue, theGovernment has established a National AIDS Council, under the chairmanship of the President,and has launched a large program to combat HIV/AIDS (supported by IDA and other donors).

16. The econonmic situation deteriorated during 1998/99-1999/2000, because of thecombined effect of the border conflict with Eritrea, the severe drought, and a pronounceddeterioration in the terms of trade. The macro-economic impact of the war was initially limited,as the Government managed to contain the fiscal impact of the conflict by financing defenseexpenditures through an increase in non-tax revenues, cuts in non-priority spending and extra-budgetary funds. Nevertheless, by 1998/99 the fiscal deficit climbed to 8.5 percent of GDP,mostly on account of a surge in defense spending and, partially, the relief effort for droughtvictims. Donor support was largely withheld because of the military conflict. This translated intoincreased domestic borrowing and a further hike of the fiscal deficit to 11.6 percent of GDP in1999/2000.

17. In addition to the impact of the war and the drought, Ethiopia was hit by a severe terms oftrade decline during 1998/99 and 1999/2000 (see Table 1). Much of this was due to a fall inexport prices (see Figure 1). While volume of coffee was initially maintained, export valuesdeclined by more than 30 percent in 1998/99 and a further 10 percent in 1999/2000. The tradedeficit increased from US$755 million in 1997/98 to US$1074 million in 1998/99, reachingUS$1246 million in 1999/2000. Ethiopia's currency came under pressure and in January 2000 theGovernment imposed temporary restrictions to protect its exchange rate (a 10 percent import dutysurcharge, a 100 percent advance deposit requirement for import applications and ceilings onimport permits). Despite these measures, the current account deficit remained high, 7.5 percentof GDP in 1999/2000, up from 1.6 percent in 1997/98. Foreign exchange reserves declined toonly 2 months of imports. With the signing of the peace agreement, the Government intensifiedthe implementation of its reform program. In January 2001, the Government lifted the importrestrictions in anticipation of external support from the donor community and debt relief with theEnhanced HIPC Initiative.

Figure 1: Trends in Coffee Export Figure 2: Terms of Trade IndexVolumes and Price

14 4 3 1 C12 5

10 a12

4 12 0.

92/93 92194 94/95 W95/9 95/97 97/98 95/99 99/00 90/0g 9292 92/94 94/95 95/9B 99/97 97/98 9e 999 99/00 00/01

l Coffee Volume -Coffee Pre [ f3EpieTemoTradeIndex

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II. THE GOVERNMENT'S ECONOMIC AND SOCIAL PROGRAM

A. OVERVIEW AND KEY GOVERNMENT OBJECTIVES

18. The Government's primary development goal is equitable growth and poverty reduction.Central to the achievement of this objective is the implementation of a long-term strategy ofagricultural development-led industrialization (ADLI), aimed at stimulating a rise of income inrural areas, where 85 percent of the Ethiopian population live, and at inducing industrialization inurban areas. The ADLI strategy was recently reconfirmed through a wide process of consultationsand is the basis of the National Development Strategy, which guides the five-year NationalDevelopment Program (NDP), during 2000/01-2004/05.

19. The NDP has provided the broad framework for the I-PRSP, which has been endorsed bythe IMF and IDA Boards on March 19 and 20, 2001, respectively. The Government is nowpreparing, in consultation with donors and other stakeholders, the full PRSP which is expected tobe presented to the Boards of the IMF and IDA in early 2002. The PRSP is expected to formulate-specific policies, aimed at reducing poverty and achieving the International Development Goalsby 2015. The medium-term Government strategy for growth and poverty reduction is based onthe following pillars:

i Raising rural incomes through increased agricultural productivity andimproved conditions for the non-farming economy. Policy instruments wouldinclude agricultural input programs, improved credit facilities and measuresto upgrade human and physical infrastructure;

- Removing impediments to private sector activity, reducing the role of thestate in the economy and accelerating export growth;

i Reforming the civil service to improve effectiveness, ensuring goodgovernance and strengthening public expenditure management;

* Improving the quality of life of the poor through the decentralized provisionof primary health care, education, water and sanitation services.

B. THE MACROECONOMIC FRAMEWORK

20. The Government's reform program is supported by a macroeconomic framework thataims at maintaining macroeconomic stability and promoting the recovery of growth. The2000/01-2002/03 program is supported by a three-year arrangement under PRGF with the IMF(see Box 1). The PRGF has been formulated within the context of a difficult balance of paymentssituation - the result of a sharp deterioration in the terms of trade, drought conditions, and theimpact of the recent conflict with Eritrea. This situation is compounded by the recent lifting ofrestrictions on imports which are necessary for the recovery of private sector growth.

21. The program's objectives are to: i) increase economic growth to around 7 percent perannum; ii) reduce inflation to low single digits; and iii) raise the import reserve cover to aboutfour months. Achieving these objectives will require the following: improving resourcemobilization through a comprehensive reform of tax policies and administration; increasingexpenditure to key social and infrastructure services through a substantial reduction in defensespending, restraint in non-social spending and reallocation of expenditure to poverty targetedsectors; and a monetary policy geared at containing inflation and increasing the level of foreignexchange reserves, while insuring adequate growth in domestic credit to the private sector.

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Box 1: Ethiopia's PRGF Program

The PRGF program is aimed at assisting Ethiopia in getting back to macroeconomic stability and sustainable economic growth byfurthering cross-border economic liberalization, sound fiscal and monetary managemeni, and improvements in financial sectorregulation.

Ethiopia's integration into the global economy will be fostered by measures to liberalize the foreign trade and exchange regines andallow market determination of the exchange rate. Specific reform steps are:* reduction of the un-weighted average tariff rate from 19.5 percent to 17.5 percent by 2003;

* abolition of the remaining restrictions on payments and transfers for current international transactions (on the availability offoreign exchange for holiday travel, and on payments for education abroad by foreign residents).

* replacing the weekly foreign exchange wholesale auction conducted by the NBE with an interbank foreign exchange marketwhere the NBE would be one of the participants.

The rmancial sector is a second area of reform. Specific measures include:

* launching a study of the National Bank of Ethiopia (NBE) to set up and consequently revise the Banking Law with a view to

increase the autonomy of the NBE and to improving the rules guiding Government borrowing;* enhancing indirect monetary control by introducing new instruments of monetary management, such as a rediscount facility and,

in the long run, a standing repo facility;* improving treasury bill auctions by eliminating the interest rate cut-off, and introducing long-term treasury bills and a book entry

system for treasury bills;* putting the management of the Commercial Bank of Ethiopia (CBE) under contract with a reputable foreign institution, followed

by rehabilitation ofthe CBE, possibly including streamnlining ofthe CBE's functions, or its institutional reorganization;* implementing the rehabilitation plans for the smaller commercial banks to reduce their non-performing loans, and strengthening

banking supervision.

The Government is embarking on a comprehensive tax policy and tax administration reform. Measures include:

* setting up a tax reform implementation task force to take the lead in the tax reform agenda;* reforming the system of indirect taxation by (i) increasing the top sales tax rate from 12 percent to 15 percent, and (ii)

introducing a Value Added Tax;* designing a three-year plan for the reduction in the effective rate of protection;* streamlining income tax legislation and reviewing the tax incentive system;* strengthening tax administration through (i) passing legislation for the introduction of tax identification numbers and for

increased collection power of revenue agencies, and (ii) establishing a large taxpayer unit.

22. Increasing growth, lowering inflation. GDP growth is projected to average around 7percent during the next three years. It will be highest in 2000/01, because of a cyclical reboundfrom drought and the disruption of war. There is evidence that adequate rains are contributing to agood harvest and both public and private investments are picking up. The Government intends tochannel donor support into infrastructure programs to rebuild roads, schools, clinics and to socialprograms. Conditions for private sector investment will be improved through a furtherliberalization of the financial sector and of the foreign exchange and trade regimes, which aresupported under the PRGF programn. Measures to increase agricultural productivity will includeinput programs, access to credit and marketing facilities and an upgrade of human and physicalinfrastructure.

23. Monetary policy will be geared to keeping inflation to low single digits. The reduction inthe fiscal deficit, coupled with the expected resumption of foreign aid, will help rebuild foreignreserves and enable a substantial increase in domestic credit to the private sector to financeprivate investment. Annual average inflation is forecast to increase initially to 5.2 percent in2000/01, up from 4.2 percent in 1999/2000, because of high oil prices and domestic tax increasesand then to decline to just above 2 percent by 2002/03.

24. Reducing the overall fiscal deficit: The medium-term fiscal stance is expected to beconsistent with a sustainable extemal account deficit and low inflation. The fiscal deficit will

9

decline to just above 5 percent of GDP by 2002/033 (see Table 2). The fiscal strategy is based, onthe revenue side, (see Box 1) on a medium-term reform of tax policy and administration aimed atincreasing tax revenues by 2'/2 percentagepoints of GDP over the next three fiscal

S4. . .Figure 3: Defense Spending as Share in Totalyears . On the expenditure side, the Public Expenditure and GDPGovemment's strategy aims at reducingu5 .

overall expenditure (excluding spending on 45

the emergency programs). Militaryexpenditure (see Figure 3) is expected to j /_ _ _ _ _:

decline sharply, from 13.3 percent of GDP -;-- -

in 1999/2000 to 7.3 percent of GDP in 1936 199 1996 1993 2500 2001 2002 2500

2000/01 and 5.6 percent of GDP in e_s_TO_ _ .P-_d____-____ l

2001/02. By contrast, spending on povertytargeted expenditures (education, health, agriculture, natural resources and roads) will begradually increased (see Table 2). Funds expected from the HIPC initiative (including the interimsupport) will be allocated to these sectors. Expenditures would be executed through the re-definedand improved sectoral development programs (see paragraphs 40-41).

25. Reducing the current account deficit. Projections of balance of payments trends assumean improvement in the terms of trade, starting in 2001/02, with coffee prices recovering and oilprices declining. After a 2.8 percent decline in the current fiscal year, export earnings are-expected to increase on average by about 12 percent a year. Imports will initially grow at a slowerrate than GDP, the combination of a sharp decline in military imports and a rise in other importsowing to the reconstruction and demobilization requirements. Food imports are expected to returnto normal levels. In the medium-term, import levels are forecast to remain high, reflecting theincrease in public and private investment. Private savings will also increase, reflectingimprovements in the financial sector and increases in personal incomes. Over time, dependenceon foreign savings will gradually decline.

Table 2: Ethiopia: Projected Macroeconomic Indicators, 2000/01-2002/03Fiscal years 2000/01 2001/02 2002/03

(annual percentage change)Real GDP 7.8 7.0 6.4Consumer prices (annual average) 5.2 4.9 2.1Terms oftrade (decline=-) -11.8 5.1 6.5

(in percent ofGDP)Overall fiscal balance (inl. grants) -6.4 -5.4 -5.1Total expenditure 31.2 29.0 28.2

- defense 7.3 5.6 5.0- poverty targeted 12.1 13.1 14.0

Gross Domestic Savings 0.7 3.3 5.3Gross Domestic Investment 17.0 19.2 20.0External current account (incl. official transfers) -5.7 -6.1 -5.0Gross official reserves (months of imports) 2.6 3.6 4.1External debt */GDP 88.8 92.2 89.5Debt service ratio** 22.4 18.9 16.8Source: Ethiopian authornties and staff eshtmate&*Before debt relief; **In percent of exports of goods and non factor services, before debt relief

26. Ethiopia is currently seeking assistance under the Enhanced Initiative for HeavilyIndebted Poor Countries (HIPC). An HIPC Updated Preliminary Document, approved by theIMF and IDA's Boards in March 2001, recommends that Ethiopia be considered for a DecisionPoint in the second half of 2001. Ethiopia's extemal debt burden remains high and unsustainable

3 Excluding temporary emergency programs for reconstruction and demobilization financed by IDA. The overall deficit includinlgemergency programs is expected to be 8.4 percent of GDP in 2000/01, 8.8 percent in 2001/02 and 6.2 percent in 2002/03.

4 However, total revenue (in terms of GDP) will increase only marginally (see Annex D), because of a decline in non-tax revenue.

10

and it represents an obstacle to economic development. Publicly guaranteed external debt willamount, at the end of 2000/0 1, to about US$5.7 billion in nominal terms. More than half of thisdebt is owed to multilateral institutions, with IDA and other multilateral institutions accountingfor 38.5 percent and 18 percent of the total debt respectively. Commercial debt is relatively small,accounting for 2.5 percent of the public and publicly guaranteed debt.

27. With the delivery of assistance under the enhanced HIPC initiative, Ethiopia's externaldebt burden will be reduced significantly. It is estimated that the debt service-to-exports ratiowould decline from 22.4 percent in 2000/01 and 16.8 percent in 2002/03 (before debt relief) to18.9 percent and 8 percent respectively (after debt relief) and average 5.5 percent thereafter5.Debt-service savings from multilateral lenders would amount to US$1.039 billion, deliveringover US$64 million per year between 2001/02 and 2008/09 and about US$48 million per yearthereafter.

28. Risks. Sustaining economic growth in Ethiopia is difficult. Output and exports remaindependent on agriculture, which leaves Ethiopia vulnerable to droughts, plant diseases andcommodity price fluctuations. As discussed in Box 2, changes in the price of coffee- whichrepresents 60 percent of Ethiopia's export earnings- or in oil prices, are of particular concern.However, these risks should be mitigated by the implementation of the reform program supportedby the ERSC, which is expected to foster private sector development and, in the medium-term,export diversification. Furthermore, the availability of finance from development partners, as wellas debt relief, will ensure a level of international reserves that will provide sufficient cushionagainst external shocks.

29. Financing requirements. Near term financing requirements for balance of payments areshown in Table 3. The total financing need is expected to average US$1228.2 million per yearbetween 2000/01-2002/03, corresponding to 18 percent of GDP. Annual disbursement of officiallong-term loans amounts to 3.9 percent of GDP a year. Foreign direct investment would represent0.9 percent of GDP a year. The emergency strategy proposed by IDA until 2002/03 would totalUS$783 million (equivalent to 2.8 percent of GDP). Debt relief under the Enhanced HIPCInitiative, would close the remaining financing gap. The financing plan is associated with anincrease in reserves from a level of 2.6 months of imports of goods and non factor services in2000/01 to 4.1 months by 2002/03.

Table 3: Financing Requirements and Sources, 2000/01-2002/032000/01* 2001/02* 2002/03*

Financing Requirements 1772.3 1006.5 905.8Current account deficit, excluding official transfers/grants 689.8 691.0 656.9Loan amortization 124.6 106.5 102.5Reserves changes of Monetary Authority 86.5 198.1 137.1Other financing requirements" 871.4 10.9 9.4

Financing Sources 1772.3 1006.5 905.8Foreign direct investment (net) 72.0 40.0 70.0Loan disbursements (excluding IDA emergency programs) 251.5 268.1 279.0

IMF credit (net) 32.3 12.3 12.3Official transfers/grants 325.0 278.9 292.0Debt relief (PC, Naples terms) and traditional debt relief (Naples terms) 822.4 32.5 20.8Emergency IDA program, including ERSC 269.0 329.0 155.0Remaining gap (HIPC) - 45.7 76.7

*Estimates

**Arrears payments (only in 2000/01), pay-off of long-term public debt, reserve built-up by commercial banks (only in 2000/01).

5Assuming a decision point in September 2001.

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Box 2: The Impact of High Oil and Low Coffee Prices on the Balance of Payments and Fiscal Accounts

This exercise examines the sensitivity of Ethiopia's balance of payments and fiscal accounts to price and quantity assumptions for coffeeexports and fuel imports for the 2000/01 to 2003/04 fiscal years. The comparison is with the base case and assumptions are incladed inthe macroeconomic framework, as outlined in Tables 2 and the Annex Tables. An updated base case is included to reflect the IDA/IMF'scurrent price projections for coffee and crude oil; and it includes the Government's expectation of a 30 percent fall in the volume ofexports during 2000/01. High and low case coffee and crude oil price assumptions were developed by DECPG to reflect the estimatedupper and lower bound of a 70 percent confidence interval on the price projections.

Table 1: Base cases and simulation assumptions for fuel and coffee price scenarios--------------- Fuel (US/bbl) ----------------------------- - Coffee (cents/kg)

2000/01 2001/02 2002/03 2003/04 2000/01 2001/02 2002/03 2003/14

Price assumptions (levels )

Base Case 30.3 26.1 24.8 24.7 180.6 190.9 209.7 219.8

Updated 26.6 22.3 20.8 19.5 168.6 162.5 19Z5 220.0

Hig,h 32.0 31.0 30.0 29.0 191.8 225.0 275.0 315.0

Low 26.0 20.0 18.0 17.0 160.0 147.5 155.0 157.5

Prices assumptions (as percent of base case)

Updated -12.3 -14.7 -16.2 -21.0 -2.8 -11.5 -4.7 4.0

High 5.5 18.9 21.1 17.5 10.5 22.5 36.2 48.9

Low -14.2 -23.3 -27.3 -31.1 -7.8 -19.7 -23.2 -25.6

Scenarios. Three scenarios are analyzed: the updated case scenario shows the effect of updated price forecasts for coffee and crude oil,and the effect of a 30 percent decline in coffee export volume due to the drought in 2000/01. The best case combines the assurmption ofhigh coffee and low crude oil price assumptions from Table 1.The low case combines the assumptions of low coffee prices and highcrude oil price. In all three scenarios, coffee export volumes are assumed to be 30 percent below the base case in 2000/01 and return tonormal thereafter.

Results

In the updated scenario, coffee exports will likely be reduced by US$72 million in 2000/01, relative to the base case, because of adrought induced 30 percent fall in output and lower world coffee prices. This will be partially offset by a US$34 million fall in energyimport costs, due to lower energy prices, and a US$16 million fall in other imports. The trade deficit is expected to increase US$22million relative to the base case. The shortfall in export revenues would progressively narrow and disappear by 2003/04. At the sametime, oil import costs would fall along with lower oil prices. The net impact would be negative in 2000/01, neutral in 2001/(02, andpositive in 2002/03-2003/04. Initial negative shocks to expenditure and the current account would tum positive by the end of the :forecastperiod.

Significant medium-term commodity price risks exist and a range of up to US$100 million in export revenues and US$40 mi Ilion inimport costs could reasonably be anticipated between the best and worst case scenarios. In the best case scenario of high coffee price andlow oil price, there is a US$53.6 million reduction in export revenues (6.1 percent), because of the assumed 30 percent fall in coffeeexport volumes. This reduces GDP (-US$19 million) and its major components (consumption and investment); but the fall in demandand lower reserves (-US$3 million) also reduce imports, which are down by US$44.4 million. Both oil and non-oil imports are lower, oilimports by US$38.1 million and non-oil imports by US$6.3 million. In the outer years of the forecast, the net impact of the scenarios ispositive.

In the worst case scenario of low coffee and high oil prices, nominal dollar GDP could be reduced by 3 percent from the base case. Thatwould be accompanied by a deterioration of the current account balance of over US$50 million in 2000/01 and around US$30 millionthereafter. Reserves would fall by US$18 million in 2000/01, and continue to fall through 2003/04 to USS53 million. Governmentrevenues and expenditures both fall, with a small, positive impact on the fiscal deficit of US$15 million - US$20 million. While theimpact might prove disruptive, it would not be large enough to pose a threat to the country's external viability since the currentaccount would deteriorate by about one-half percent of GDP and reserves would fall by less than 7 percent. It is also likely that additionaldonor financial support would be mobilized to help Ethiopia maintain the momentum of its poverty reduction and growth program, in theevent of another shock.

C. THE GOVERNMENT'S MEDIUM-TERM REFORM PROGRAM

30. The following sections describe the Government's medium-term reform program and thespecific measures that are adopted under the ERSC. The ERSC supports the continuation of astable macroeconomic framework, which will be monitored in the context of the PRGF, and thereallocation of public expenditure from defense to poverty-targeted sectors. The budget for2000/01, approved in November 2000, is consistent with the objectives of the medium- term

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macroeconomic framework. Latest indications are that budget execution is broadly on track,albeit with much lower than projected defense spending. Projections on the basis of the earlymonths would indicate that these defense expenditures are likely to be significantly lower thanapproved in the current budget. The ERSC supports policy improvements in the following areas:(i) Public Sector Management; (ii) Public Expenditure Policy and Management; (iii) PrivateSector Development and Export Competitiveness.

D. PUBLIC SECTOR MANAGEMENT

31. Main Issues. Weaknesses in public administration have been acknowledged since theearly 1990s. Incentive problems, primarily caused by inadequate wages, have hindered thedevelopment of a motivated, capable, and professional civil service. There is a clear need todevelop arrangements that place a premium on improved service delivery and client orientation.Implementation of administrative reforms is particularly challenging because of the broad powersand authority afforded to sub-regional governments in the 1994 Constitution. The process ofregionalization offers civil servants opportunities to be more responsive to local needs butdemands much more in terms of front-line service delivery performance, client-orientation, andcapacity. By contrast, the role of the federal Govemment, particularly in areas of national interestsuch as policymaking, standards setting, and monitoring, requires greater clarification as regionalauthorities take on the bulk of responsibility for the delivery of essential services.

32. Ethiopia's Civil Service Reform Program. In 1996, the Civil Service Reform Program(CSRP) was launched as part of an overall effort to build a transparent, efficient, effective, andethical civil service that would meet Government's standards for improved governance. The fivemajor sub-programs of the CSRP comprise: (i) Expenditure Control and Management; (ii) HumanResource Management; (iii) Service Delivery and Quality of Service; (iv) Top ManagementSystems; and (v) Ethics. While the Program is comprehensive in scope, implementation haslagged in the last two years because of the effects of the war, poor coordination, and limitedmanagerial capacity. Strengthening the civil service is now a high priority for the Government asit seeks to carry out the ambitious reconstruction and development strategy articulated in the 1-PRSP.

33. Elements of a renewed implementation strategy for the CSRP over the short- to medium-run include: (i) establishing the legal framework for a modern civil service; (ii) improving servicedelivery performance; (iii) creating an enabling environment for civil servants by improving payand remuneration; and (iv) enhancing the transparency of personnel management systems.Progress has been made in these four areas, which build on the Human Resources Management(HRM), Service Delivery and Quality of Service; and Ethics Sub-programs of the Government'sCSRP. Annual Public Expenditure Reviews (PERs), conducted jointly by the Govemnment, IDAand other donors, have increasingly focused on the institutional constraints that hinder effectivepolicy and program implementation at the federal and regional levels.

34. The status of key administrative reforms, which are priorities in the CSRP and would besupported in the ERSC and in follow-on operations, are as follows:

Legal framework: The Federal Civil Service Commission (FCSC) hasprepared a draft Civil Service Law. Drawing on international 'goodpractices', it provides a broad framework for management of a modern, andcompetitive civil service. It includes provisions for a new code of conduct, asystem of job classification and grading, an open appraisal system, grievanceand appeals procedures, access to personal information, as well as sanctionsagainst various forms of misconduct.

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* A Civil Service-wide Code of Conduct, as well as a draft "National Charterof Citizen's Rights and Responsibilities," are being developed in parallel andprovide for the strengthening of accountability relationships betweengovernment institutions and the public at large. Specifically, the Charterwraps together service and ethical conduct standards, access to information,procedural fairness, and protection from wrongdoing. Taken together, thesedocuments constitute the state-of-the-art informal rules for ethical standardsin the civil service. A program for ethics education would ensure that civilservants and citizens are aware of the new norms and standards that areexpected of them.

* Improving service deliverv performance: The Government, in consultationwith federal and regional authorities, is developing a National Policy onService Delivery to improve the management and client-orientation ofinstitutions involved in the delivery of essential services. The policy, whichrecommends modern management practices such as increasing accessibilityto clients, enhancing transparency, and achieving cost-effectiveness,represents an initial step towards a greater performance-orientation across allGovernment levels.

* Civil service pay and restructurinz: Inadequate pay for civil servants hasresulted in an increasing incidence of moonlighting, poor work performanceacross grade and skill levels and a steady migration of skilled staff to privatefirms, NGOs, and donor agencies. Remuneration surveys indicate that privatesector wages are on average about 125 percent higher than those in the civilservice. Pay for civil servants at the lowest grades is not sufficient to meeteven a quarter of the requirements for household subsistence. A JobClassification and Grading (JCG) exercise has been initiated to determineappropriate pay levels based on an analysis of internal job comparisons andthe existing system of position classification. Over the next two years theFCSC intends to integrate the findings of the market comparator surveys andthe JCG exercise; and to elaborate various scenarios for increasing wages andrestructuring the federal civil service within medium-term fiscal targets.Current staffing levels may have to be revised in light of the proposed payincrease, in order to avoid unwanted budget pressures.

* Enhancing the transparency of personnel management systems: The federalGovernment intends to decentralize various personnel managementfunctions, such as recruitment, to line agencies. In preparing for this role, theFCSC is developing a Government-wide Human Resource ManagementInformation System (HRMIS), which would ensure access to real-timeinformation on personnel management within the federal civil service. Acomputerized Records and File System, as a first step for a well-functioningHRMIS, is being prepared. Once the planned development of a Wide AreaNetwork (WAN) across federal line agencies is also completed, it shouldprovide a platform for the roll-out of the HRMIS as well as the FinancialManagement System in the future. The Government intends to adopt anintegrated policy on information and technology, to delineate standards forhardware and software, as well as the recruitment of information technology(IT) personnel.

35. Expected results from CSRP. Ethiopia expects that implementation of the CSRP wouldachieve several benefits. First, a more efficient civil service, the result of an increased awareness

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among civil servants of rights and responsibilities (which will be monitored through publicofficials' surveys); and of an improvement in managerial practices and incentives, including abetter pay for both federal and regional civil servants, leading to a greater retention of qualifiedpersonnel. Second, greater citizen participation in monitoring performance of ministries,departments, and agencies. Finally, increased availability of personnel data and other informationacross federal and regional institutions required for planning purposes.

Program Supported by the ERSC

36. The ERSC supports the Government's ongoing CSRP, and specifically, the key areas ofadministrative reform discussed above, in order to achieve expected results. Pursuant to this, thefollowing measures have been taken by the Govemment:

* A draft Civil Service Law has been approved by the Council of Ministers.

* A diagnostic survey of Job Classification and Grading has been launched.

* The 1999 labor market survey on wage differentials between private-publicsector jobs has been completed.

* Criteria for integrating findings from JCG and labor market survey in view offormulating a medium-term pay and employment policy have beendeveloped.

* The Council of Ministers has adopted a Draft National Policy on ServiceDelivery.

v The piloting of a software for records and filing system, a prerequisite for theHRMIS, has been completed and the roll out of the system across federal lineagencies has been initiated.

Medium-term program

37. Actions before end 2001/02. Subject to approval by Council of People's Representatives,the Government intends to implement, during the next fiscal year, the Civil Service Law, as wellas the National Policy on Service Delivery. These laws are critical to a variety of other civilservice reform activities planned under the CSRP during 2001/02: a Civil Service-wide Code ofConduct, in line with the National Charter on Citizen's Rights and Responsibilities; the adoptionby the Council of Ministers of medium-term pay and employment policy for federal civil serviceconsistent with the Macro-Economic and Fiscal Framework; the development of ethics trainingcurriculum for federal civil servants; and the introduction of report cards to monitor clientfeedback in federal institutions piloting the national Policy on Service Delivery. The Governmentalso expects to complete the automation of all personnel data for federal civil servants in theFederal Civil Service Commission and federal line agencies. Finally, an Inter-ministerialTechnical Committee to develop an IT policy for systems integration will be established by July2001. The Committee will oversee the preparation of an IT policy, which will be reviewed andapproved by the Council of Ministers during next fiscal year.

38. Actions before end 2002/03. During the fiscal year 2002/03, it is envisaged that theGovernment will begin implementing the pay and employment strategy in conjunction with thenecessary restructuring of line agencies and departments. Institutional codes of conduct as wellas departmental citizens' charters (service standards, provisions for access to information,procedural fairness, and protection from wrongdoing) will also be drafted in parallel, along withimplementation of good management practices recommended in the National Service DeliveryPolicy. The required ethics and management training will be provided as well. Taken together,

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these measures would provide the state-of-the-art in the formal rules for an ethical andprofessional civil service. Results of client report cards will be published. As regards automationof personnel data as part of the information required for a more decentralized approach to civilservice management, the Government will oversee the installation of a Wide Area Network andthe roll-out HRMIS across federal institutions.

E. PUBLIC EXPENDrrURE POLICY AND MANAGEMENT

39. The Government is undertaking a comprehensive reform program for strengtheningpublic expenditure policy and management. It includes two components: i) efforts to reallocateresources away from military towards development related activities. These efforts are aimed atattaining the social and poverty reduction targets identified in the I-PRSP; and, ii) an overall planfor assuring sound public resource management. Donor agencies-bilateral and multilateral-aresupporting the Government's strategy to strengthen public expenditure through a number oftechnical assistance programs. Moreover, annual PERs are being jointly undertaken with otherdonor agencies to assess the strengths and weaknesses of this strategy, and help the Governmentto move forward on the reform agenda.

Restructuring public expenditures

40. The Government's resource allocation strategy suffered a setback during the receni.conflict with Eritrea. Defense spending peaked at 13.3 percent of GDP (nearly half of the totalpublic expenditure budget) in 1999/2000, up from 8.7 percent of GDP in 1998/99. By contrast,poverty targeted expenditures fell from 10.8 percent of GDP in 1998/99 to 8.6 percent of GDP ini1999/2000 (see Table 1). However, part of the rise in military expenditure was achieved throughan increase in total spending levels, and actual recurrent spending on the social sectors declinedonly slightly during 1999/2000. In the 2000/01 budget the Government has increased allocationsto the health and education sectors (see Table 4). A three-year plan to progressively reduce!defense spending and to use the released resources for poverty-targeted sectors is identified underthe I-PRSP and is monitored under the PRGF agreement. The I-PRSP also identifies6 targets for anumber of social indicators. These targets will be fully developed in the PRSP.

41. The Government intends to use debt relief under the enhanced HIPC Initiative to financegrowth-promoting and poverty-reducing activities. The share of spending allocated to thepoverty-targeted sectors in total government expenditures is expected to rise from 26 percent in1999/2000 to 45 percent (excluding HIPC-financed expenditure), or 50 percent (including HIPC-related outlays) by 2002/03 (or from 8.6 percent of GDP to 14 percent of GDP, including HIPC,as shown in Table 4). Education and health expenditures would be executed within theframework of the Sector Development Programs (SPDs), initially introduced in 1998. Pursuit ofthe programs in the last two years has been hampered by lack of funding, due to the war and tothe withdrawal of donor grants. Implementation and service delivery bottlenecks also played arole. The Govemment has completed a review of the SDPs in Education and Health. In addition,it has recently convened a Task Force to analyze implementation issues. The Task Force hassubmitted a report to the MoF on the implementation bottleneck of the SDPs and the MoF isdeveloping recommendations to address these. Each year the Govemment will make sure thatexecuted public expenditure for poverty targeted sectors are consistent with allocated expenses.

6 The Government's stated targets, to be achieved between 2000/01-03, as laid out in the I-PRSP, include: i) to increase access l obasic health services from 51 percent of the population to 55 percent; ii) to increase child immunization rates from 60 percent to 70percent; iii) to increase the gross primary enrollment rate from 46 percent to 50 percent; iv) to reduce repetition rates in Grades 4-8

from 12.1 percent to 6.4 percent; and v) to improve the ratio of girls to boys in primary school from 37.8 percent to 45 percent.

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Table 4: Ethiopia. General Government Poverty-Targeted and HIPC Relief-Related Expenditure (inpercent of GDP)

1999/2000 2000tO1 2001/02 2002/03

Pre-EHIPC After Pre-HIPC AfterRIC HIPC

Poverty-targeted 8.6 12.1 12.3 13.1 12.8 14.0expenditure

Recurrent 4.5 5.0 5.0 5.0 5.0 5.2Of which: 2.5 2.9 3.0 3.1 3.0 3.2EducationHealth 0.8 0.8 0.9 0.9 1.0 1.0

Agriculture 1.0 1.0 0.9 0.9 0.9 0.9

Roads 0.2 0.2 0.2 0.2 0.1 0.1

Capital 4.1 7.1 7.3 8.0 7.7 8.8

Education 0.7 1.0 1.1 1.2 1.2 1.3Health 0.3 1.1 1.1 1.4 1.1 1.6

Agriculture 0.9 1.0 1.0 1.0 1.0 1.1

Naturalresources 0.5 1.1 1.1 1.2 1.1 1.2

Roads 1.6 2.9 3.1 3.3 3.3 3.6

Memo

Defense Spending 13.3 7.3 5.6 5.0Source: Government of Ethiopia and lMF estimates

Strengthening public expenditure management

42. Main issues. Ethiopia's public finance management system is disciplined, spending is incompliance with budgeted allocations, and corruption and leakage are low relative to othercountries. Budget allocations are honored by the federal Ministry of Finance and the regionalfinance bureaus, and are adhered to by the spending agencies as hard budget constraints. Re-appropriation from one budget head to another requires legislative approval at the regional orfederal level. While there are bottlenecks in timely reporting of expenditures at the regional leveland below, generally the variations between the budget allocations and actual outcomes areminimal. Nevertheless, there is considerable scope for improving Ethiopia's public expendituremanagement system. For instance, linkages between planning, policy and budgetary allocationsare weak, and in most cases, expenditure allocations are based on immediate fundingrequirements rather than policy choices. Second, capital and recurrent budgets follow separatebudget processes. And, finally, timely preparation of accounts and then audits requires fasterreporting from the lower levels of Govermnent.

43. Reforming public expenditure management is inherently a long-term process that requiresbroad ownership as well as a well-developed sequencing strategy. The reform task in Ethiopia isboth complex and difficult for two main reasons. First, there are four tiers of government -federal, regional, zonal and woreda - and each of them has responsibilities for resourcemanagement and service delivery. And second, at each level, but more pronouncedly at the lowerlevels, there are severe technical capacity and resource constraints. Sub-national governments inEthiopia share public spending responsibilities in sectors such as agriculture, water development,health and education. Within health and education, regional governments are responsible for allservice delivery at the primary and secondary levels.

44. Ethiopia's Public Expenditure Management Reform Strategy. The main objective ofthe reform strategy is to put together a modern public expenditure management system that

17

enhances accountability and effectiveness. The overarching framework is detailed in th,Expenditure Management & Control Program (EMCP) of the CSRP. The resource managementstrategy is also reflected in the Government's I-PRSP and is supported by the ERSC. The maincomponents of Ethiopia's public expenditure management strategy (and their current status) aredetailed below:

* Public Investment Program (PIP). 1997 legislation introduced a three yearrolling PIP which, however, was not implemented. A Macro-economic andFiscal Framework (MEFF) was also prepared but not approved. As a result,requests for the capital.budget by public bodies have not been based on anymedium-term planning and/or prioritization. The conflict with Eritreacontributed to diverting the required attention of the authorities on theimplementation of the PIP. Lack of confidence in the fiscal forecasts alsoplayed a role.

. Financial Calendar. Predictability and timely availability of funds arenecessary for spending units to be able to execute their budget properly.Without the annual budget conforming to a pre-set calendar, regionalgovernments may find out very late in the fiscal year the amount of the annualsubsidy. In order to remedy this problem, the Government has put together afinancial calendar (Budget Reform Design Manual, Version 2.1, February 17,2000), and adherence to it is expected to begin soon.

* Preparation of Accounts and Reporting. A project team has been working toimprove the accounting system at all levels of Government with the aim ofreducing the backlog in reporting the audited accounting. Accounts are nowbeing prepared for 1997/98 and 1998/99 for which data are complete.Training has been imparted to 2000 staff at the woreda level.

* Audit and Financial Management System . The Govemment is committed toundertake reforms on the internal and external audits and on the financialmanagement system.

> Internal Audit. A Project Group is putting together a reformprogram for the internal audit system. With externalassistance, the Group has prepared a Manual on Principles ofAudit and a Procedural Guide.

> External Audit. The Office of the Federal Auditor General(FAG) is responsible for providing the external oversightfunction in Ethiopia. Appointed by and reporting to theCouncil of People's Representatives, the FAG has a tenureof five years. Each regional state has its own office of theAuditor General. Besides auditing the accounts prepared bythe MoF, the FAG also inquires selectively about funds ofbudgetary institutions and undertakes performance audits.Accounts for all category of spending, including defense, arereported to the FAG's office. The reform program in the areaof external audit includes financial and performance audits.Training manuals and procedural guides are beingdeveloped, as well as a design manual for financial audit.

> Financial Management System. The financial managementsystem is being improved, to facilitate on-time preparationand reporting of Government accounts at all levels. All the

18

finance bureaus of regions have been computerized and astandard PC-based software has been introduced. The futureplan is to create a financial data base that links all accountsat the federal and regional levels. Training to build capacityis being sequenced at the federal, regional and woreda levels.

* Public Expenditure Plan (PEP). The Government realizes that preparing acomprehensive multi-year PEP requires capital and recurrent spendingdecisions to be taken together. Currently, while the Ministry of EconomicDevelopment and Cooperation (MEDaC) prepares the capital budget (and ismainly responsible for the PIP), the MoF separately puts together therecurrent budget. A similar setup exists at the regional level where bureaus ofplanning and finance undertake the respective tasks. The Government hasnow proposed a PEP, i.e. a medium-term, three-year rolling expenditure planfor each public body at a program level that includes total - capital andrecurrent - expenditures. It has all the necessary elements to monitor andadjust (as necessary) the links between budgetary inputs and developmentoutputs/outcomes. The PEP intends to develop unit costs and eventuallymove towards performance budgeting.

Program Supported by the ERSC

45. The ERSC supports the initial stages of the Government's medium-term program forstrengthening public expenditure in the following ways: (i) helping with the transition to post-conflict re-establishment of the social sector programs, mostly through restoring funding levels;(ii) supporting the strengthening of implementation capacity, to overcome absorptive bottleneckson the utilization of additional funding; (iii) laying out the basis for longer-term social sector andpoverty programs, through review and reformulation of sector strategies and targets; and (iv)supporting the components of the expenditure management program discussed above. Specificmeasures that the Government has undertaken before Board presentation of the ERSC include:

* Completion of the review of SDPs in Education and in Health.

* Submission by the Task Force to the MoF of a report on implementationbottlenecks of SDPs (procurement, financial management, monitoring andreporting).

* Agreement on an action plan to develop an improved FMIS.

* Provision of an action plan to indicate progress and future plans for improvingthe accounting system, in particular for reducing the current backlog ofaccounts preparation and reporting for audit.

* The establishment of a committee with membership from the Ministry ofEconomic Development and Cooperation (MEDaC) and Ministry of Finance(MoF) to, inter alia, facilitate Government-donor dialogue on publicexpenditure issues. The above committee will hold semi-annual meetings withdonors on public expenditure issues.

Medium-term program

46. Before the end of 2001/02, the Government plans to undertake the following measures:by October 2001, the Council of Ministers will adopt a MEFF and a Public Investment Program(PIP), which will lead to the budget for 2002/03 and by December 2001 both will be submitted tothe Council of People's Representatives. It will also prepare any necessary legislation relating to

19

the PEP and present it to the Council of People's Representatives for approval. Furthermore, byJune 200 1 a technical coordination committee comprising staff from MEDaC and MoF will beconstituted, with the aim of better integrating current and capital spending. MEDaC, illcoordination with the MoF, will also prepare a plan laying out the resource requirements and atimetable to help the regional states in carrying forward their multi-year planning and budgetingprocess. The Government will adhere to the financial calendar (as specified in the Budget Desigr.Manual) for the annual planning and budgetary cycle leading to the budget of 2002/03, and notif,Regions of estimated subsidies for that budget in conformity with the financial calendar (Januar.'9 - January 16, 2002) as outlined in the Budget Reform Design Manual. As to the backlog ofaccounts and audits, the Government intends to reduce it from the current 5 years to 3 yearsFinally, the Government will implement the findings of the FMIS study; reformulate the SDPs inHealth and Education in line with PRSP priorities; and adopt the recommendations to resolve thebottlenecks for improving the implementation of the SDPs.

47. Actions before end 2002/03. To protect the funding for basic social services at thegrassroots level, the Government has signaled its intention to re-direct additional resources to theregional Governments that have responsibility for delivery of core educational and healtlservices.7 Before the end of 2002/03, the review and reformulation of the education and healthsector strategies and targets will be completed as part of PRSP. After approval of the MEFF andPIP by the Council of People's Representatives, they will be presented to the donor community.This will enable donors to design their aid programs in conformity with budget priorities. Tobegin the implementation of the PEP at the regional level, the Government will prepare an actionplan laying out resource requirements and timetable to help regions carry out their multi-yearplanning and budgeting process. Finally, the reform of the internal and external audits, as wellthat of the financial management system, will be further advanced.

48. Expected benefits of the actions and reforms are many and include: adequate funding forpoverty targeted sectors, which would lead to more efficient public services, and to improvedhealth and education indicators, a functional multi-year planning and budgeting exercise at thefederal level; predictable and timely availability of funds leading to better procedures fi)rplanning and budgeting at the regional level; and improved budgeting and planning through betterbalance between capital and recurrent expenditures. Finally, a reduction in the existing backlog ofaccounts preparation, reporting and auditing and an improved financial management system.

49. Expenditure tracking. Public expenditure reforms will result, in the medium term, in asignificant improvement in the process of targeting public expenditures. Expenditures are ncwtracked through the preparation of joint annual PERs by the Government, the World Bank andseveral donor agencies. Under the ongoing PER, the Bank and DflD are working with the regionsto analyze and strengthen expenditure tracking at the regional level. Annual reviews of the SD'P'sby the Government and donors, would suggest corrective action where necessary. In addition,annual household surveys, as well as the poverty analysis undertaken by the welfare monitoringsystem (WMS) would enable the monitoring of public expenditure from a quality viewpoint, andthe assessment of the impact of public spending on the poor.

F. PRIVATE SECTOR DEVELOPMENT AND EXPORT COMPETITIVENESS

50. Issues: Ethiopia has shifted from a socialist to a market economy and some elements for astrong take-off of the private sector are already in place. These include macroeconomic stabilily,

Responsibility for delivery and funding of primary and secondary education lies with the Regions. The Federal Government hasresponsibility for overall policy, some general administrative functions, and tertiary institutions. Similarly in health care, primaryhealth care, health posts and centers, and most hospitals are the responsibility of the Regions.

20

market liberalization and expansion of education. However, many constraints still hinder privatesector development:

* Regulatory constraints impose high transaction costs on business operationsand discourage foreign investment.

* The share of exports to GDP is one of the lowest in the world and there islittle diversification of exports. The Government has broadly accepted thethrust of the analysis contained in a 1997 Bank Report on Exports8 . TheReport proposed a comprehensive set of measures to boost export growth,particularly in the manufacturing sector. Following the Report'srecommendations, a number of policy improvements have been made inseveral key areas since 1997: the elimination of ex-ante price verification forall exports, except coffee, the simplification of procedures for non-equitycollaboration with foreign firms, and the introduction of a duty draw-backsystem and export finance guarantees. In the 2000/01 budget a temporary 10percent surcharge on imports was eliminated, thus reducing average tariffrates to 19.5 percent. However, partly because of the slow implementation ofthe reform program, export growth rates have not yet reached a satisfactorylevel. Actions implemented under the ERSC would complete the set ofmeasures recommended in the 1997 Report, while improving on theformulation of some of the measures already taken.

- Ethiopia's privatization program began in March 1995, about a year afterProclamation No. 87/94 had established the Ethiopian Privatization Agency(EPA). Since then, 166 state owned enterprises (SOEs) were sold, mostlyretail outlets, restaurants and small scale firms. The privatization process iswell organized, and conducted in an open and competitive framework. Thecurrent privatization phase involves enterprises that are large and in keyindustrial sectors (e.g. leather industry, textiles, construction, mining,agricultural industry). The Government is planning to bring to the point ofsale 111 SOEs by 2002/03, thus completing the program of privatization inthe agriculture and industrial sectors.

* In agriculture, an efficient fertilizer market, which is a crucial condition forincreasing yields, has so far failed to materialize. In part, this is because thegovernment Extension Intervention Program,9 which provides fertilizer tofarmers, is being implemented at a larger scale and much beyond the initialtwo years for which it was originally intended. It is estimated that theGovernment share of the fertilizer market has by now risen to some 60 to 80percent at different locations while much of the balance is with thecooperatives.

* Private participation in infrastructure (PPI) continues to face significantobstacles. Much remains to be done to increase competition in serviceprovision. So far, PPI has been piecemeal (a decision was recently taken toallow private participation in power and telecommunications) and there is aneed for an overall policy framework.

See World Bank (1997), 'Ethiopia: Export Development strategy', Report no. 17098-ET9 The Govemment is undertaking a massive extension intervention program (EIP) which has by now covered some three million of the7.5 million farmers in the country. Central to this extension effort, which is also described as Package Program, is the widespread andefficient use of fertilizers by farmers to raise their crop productivity.

21

* Entry barriers still represent an important obstacle to attracting foreigninvestment. Furthermore, institutional weaknesses are hindering thedevelopment of an efficient land lease market and the use of land as collateral.

Program supported by the ERSC

51. The specific measures taken by the Government in the context of the ERSC represent asignificant progress in tackling the first four issues. They are an important step in an ongoingprocess of improving the business environment and reducing the role of the State in the economy,underpinned by regular dialogue with the Bank. The remaining issues (obstacles to FDI, landmarkets and private participation in infrastructure) will be tackled in follow-on operations. TheGovernment has:

* Signed a contract with consultants to initiate agreed study to identifyregulations which hinder private sector development (study expected to becompleted by March 2002).

* The Export Promotion Council has reestablished its regular meetings aimedat providing a forum of discussion to improve the environment for exports.

• The Council of Ministers has adopted a new Voucher-based Duty Exemptionscheme, open to all exporters with a genuine export order and to exportersusing Franco-valuta imports.

* The National Bank of Ethiopia (NBE) has issued an Amended Directive onExport Credit Guarantee Scheme allowing participating banks to chargemarket interest rates, limiting the maximum collateral requested to newentrants and simplifying eligibility criteria.

* The coverage of NBE export price monitoring has been restricted only toproducts where international prices are available from recognizedinternational sources.

- Export price information responsibility has been shifted out of NBE to theExport Promotion Agency.

* The requirement for the presentation of the Standards Authority's qualitycertificate as a condition for export clearance where the buyer confirmshis/her acceptance of a different specification, or internationally acceptedstandard, and his/her acceptance of certification of compliance by a partyother than the Authority has been waived.

* Preparation for privatization of 21 enterprises (i.e. compile all documentationnecessary to send invitation to tender) has been completed.

* Preparation for privatization of 13 enterprises (i.e. select winning bidders forpreparation) has been initiated.

* A contract with the selected consulting firm to conduct an agreed study onfertilizer marketing and credit has been signed.

* Pending the results of the study, Government has recommended to all regionalgovernments to procure fertilizer for distribution under its extension programsonly on the basis of competitive bidding procedures, as is already the practicein some regions.

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Medium-term program

52. Actions before end 2001/02. During the next fiscal year the Government is planning toundertake a number of important policy measures in the area of private sector development. Toincrease export competitiveness, the Suppliers Credit directive will be extended to cover supplierscredit for inputs for the purpose of exports on a cash basis; the NBE will allow for automaticregistration, and drop the debt/equity ratio requirement for suppliers credit in relation to exports;the export ban on raw hides and skins will be replaced by an export duty; the amended directiveon the Export Credit Guarantee scheme will become operational early in the financial year; and,to facilitate the application of the Voucher Scheme, standard coefficients for imported inputs thatare needed for most common exports will be prepared. To improve the business environment andattract foreign investment, the Government will eliminate case by case screening of foreigninvestment not specified in the Negative Lists (the four lists which specify the areas of activitywhere private investment is restricted), and eliminate the minimum investment requirement for100 percent export investments. The Ethiopian Telecommunication Corporation will be opened toprivate sector participation. The privatization program will be accelerated by bringing to the pointof sale at least 40 additional enterprises (of which at least 10 enterprises before September 2001)and by completing preparation for privatization of at least 20 enterprises. Furthermore, theGovemment will implement the action plan derived from the study on regulatory constraintsundertaken in the previous year; it will initiate two additional studies, the first on the regulatoryframework of public utilities (gas, electricity, water), the second on the process of approving andclearing of export shipment. As to land markets, the Government intends to take a number ofmeasures: first, the Urban Land Lease Proclamation (80/1993) will be reviewed to ensure thatbanks taking leases as collateral are able to realize the full value of that collateral at any time;second, it will recommend to each region to establish and maintain a Register of Land availablefor investors (to include all charges and rights over each parcel of land fully investigated), and toenter into negotiated arrangements with private investors to develop industrial parks. Finally, theGovernment will prepare an action plan on the basis of the study on fertilizer marketing andcredit. Pending the result of this study, it will limit government's direct supply of inputs to theExtension Intervention Program farmers to no more than two years (three years in woredas wherealternative channels are not available).

53. Actions before end 2002/03. Steps to continue the medium-term agenda for privatesector development include: (a) performance assessments of a number of policy measures takenin previous years, including the voucher-based duty exemption scheme, the Export CreditGuarantee Scheme and the Suppliers Credit directive; (b) implementation of recommendationsfrom the studies on approving and clearing of export shipment and on the regulatory frameworkof public utilities; (c) a review of the minimum investment requirement for foreign investors(including for production for the domestic market); (d) completion of the privatization program of111 state owned enterprises which had begun in 2000/01; and (f) implementation of the actionplan derived from the fertilizer marketing and credit.

54. Expected results from reforms to promote private sector development and to improveexport competitiveness include: an improved and simplified regulatory framework for privatesector development; an increase in export activity, the result of a greater access to duty-freeinputs and credit and simplified customs procedures for exporters. In the medium-term, continuedprogress on trade and foreign direct investment liberalization, as well as market deregulation, willensure the emergence of an open and competitive economic system and will facilitate theintegration of Ethiopia into the world economy.

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III. THE PROPOSED CREDIT

A. CREDIT RATIONALE AND COMPONENTS

55. The proposed ERSC supports the Government's efforts in stabilizing the economy a;dmoving back to a sustainable path of growth, as a necessary condition for poverty reduction. Tlheproposed Credit would allow the Government to reduce domestic financing of the deficit andrebuild foreign exchange reserves; it would finance increased private sector imports associatedwith the removal, in early 2001, of restrictions in the foreign exchange market; and it would helprestoring key economic and social services, and rebuilding the institutional capacity needed todeliver them.

56. The Credit supports the implementation of a sound macroeconomic program, includingthe reallocation of public spending towards poverty-reducing interventions. It also supports threemain components of the reform program outlined in the I-PRSP, namely: i) public sectormanagement; ii) public expenditure policy and management; and iii) private sector developmentand export competitiveness. Other aspects of the reform program, e.g. financial sectorliberalization and foreign exchange markets reform, are supported by the IMF in the context ofthe PRGF and by other stakeholders.

Link to the Country Assistance Strategy and the PRSP

57. The last full CAS for Ethiopia was approved in 1997. Following the Cessation ofHostilities Agreement in May 2000, IDA prepared the current Interim Support Strategy. Thestrategy, endorsed by the IDA Board on December 5, 2000 is aimed at addressing the countr,'simmediate post war recovery needs during the coming 12-24 months. A new CAS for Ethiopiawill be prepared in 2001/02. The CAS will draw on the PRSP, and will support the effectiveutilization of additional resources that may become available under the Enhanced HIPC Initiative.

58. The ERSC provides transitional support for economic recovery from the conflict w:thEritrea and a drought, against the background of a sharp decline in the terms of trade. Moreover,it supports some of the reforms outlined in the I-PRSP and expected to be further extended in IthePRSP. If progress remains on track, the PRSP could be presented to the Boards of the IMF andIDA in early 2002. The scope and pace for moving into a possible policy-based follow-onoperation would depend, inter alia, on progress with core diagnostic work in the areas of civilservice reform, public expenditure and financial management systems, procurement, and socialand private sector development.

Coordination with the IMF and Other Donors

59. Effective donor coordination is an important goal of IDA's assistance strategy inEthiopia. The staffs of IDA and the IMF have worked closely with the authorities in designing themacroeconomic framework and the program of structural reforms. Joint IMF-IDA missions arecurrently helping the Government in the preparation of a sound financial sector reform. The staffsof IDA and the IMF have completed and presented to the respective Boards a joint staffassessment of the I-PRSP in March 2001. An agreement has been reached with the Governmenton a timetable and process for preparing the full PRSP in the next fiscal year. Together with IDAand the IMF, several development partners are actively involved with the Government in thepreparation of the PRSP. Since the signing of the peace agreement, a number of donors haveindicated their willingness to step up both technical and financial assistance to support theimplementation of the Government's medium-term reform program. The European Union, the

24

UNDP and other development partners are financing some of the studies and the technicalassistance required by the ERSC.

B. CREDIT AMOUNT AND TRANCHING

60. The Government of the Federal Democratic Republic of Ethiopia would borrow anamount of US$150 million equivalent. The credit would be released in one tranche uponeffectiveness.

C. SUMMARY OF FiDucIARY ARRANGEMENTS

61. Disbursements: Disbursement arrangements will follow the Bank's standard simplifiedprocedures for structural adjustment credits. The proceeds of the credit will be disbursed againstsatisfactory implementation of the reform actions before Board presentation. Disbursements arenot linked to specific imports or expenditures. Upon effectiveness, IDA will deposit the proceedsinto a deposit account at the NBE at the request of the Borrower. A deposit account will beopened at the NBE before effectiveness. If deposit account proceeds should be used for ineligiblepurposes as defined in the Development Credit Agreement, IDA will require the Borrower toeither: (a) return that amount to the account for use for eligible purposes; or (b) refund theamount directly to IDA, in which case IDA will cancel an equivalent un-disbursed amount of theCredit. The administration of the credit will be the responsibility of the Ministry of Finance.

62. Audits: If requested by IDA, the borrower will arrange for the audit of the deposit account.The account would be audited by an independent extemal auditor acceptable to IDA, based onIntemational Standards on Auditing applied on a consistent basis. The said audit report would besubmitted to IDA as soon as available, but in any case not later than six months after the end ofthe Government fiscal year. Since the National Bank of Ethiopia will be responsible for themanagement of the overall borrower resources, the Borrower will submit the annual auditors'report on the accounts of the National Bank of Ethiopia.

63. Reports: The Borrower will fumish to IDA quarterly reports on receipts anddisbursements from the deposit account.

D. REFORMS SUPPORTED BY THE ERSC

64. The Federal Democratic Republic of Ethiopia has embarked on a medium-term reformprogram, being implemented within the framework of the I-PRSP. The main elements of thereform program are set out in the Letter of Development Policy (Annex B) and summarized in thePolicy Matrix (Annex A).

65. I-PRSP and Macroeconomic Framework. In their recent review of the Joint StaffAssessment (ISA) of Ethiopia's I-PRSP, the Executive Directors of the IDA and of the IMF haveconcluded that the I-PRSP provides a sound basis for the development of a PRSP and for IDAconcessional assistance. Ethiopia's macroeconomic framework is supported by a PRGFarrangement.

66. Ethiopia has completed the following reform actions prior to presentation of theproposed Credit to the Board:

* Adoption of draft Civil Service Law by the Council of Ministers.

* Adoption by the Council of Ministers of the Draft National Policy on ServiceDelivery.

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* Launch of diagnostic survey of Job Classification and Grading.

* Completion of 1999 labor market survey on wage differentials betweenprivate-public sector jobs.

* Development of criteria for integrating findings from JCG and the labor marketsurvey in view of formulating a medium-term pay and employment policy.

* Establishment of a committee consisting of staff from the MEDaC and theMoF to, inter alia, facilitate the Government-donor dialogue on publicexpenditure issues. The above committee will hold semi-annual meetings withdonors on public expenditure issues.

* Agreement with IDA on Action Plan to develop an improved FMIS.

* Adoption by the Council of Ministers of new Voucher-based Duty exemptionscheme, open to all exporters with a genuine export order and to exportersusing Franco valuta imports.

* NBE has issued an Amended Directive on Export Guarantee Scheme allowingparticipating banks to charge market interest rate, limiting the maximumcollateral requested to new entrants and simplifying eligibility criteria

* The coverage of the NBE export price monitoring has been restricted only toproducts where international prices are available from recognized internationalsources.

- Export price information responsibility has been shifted out of NBE to theExport Promotion Agency.

* The requirement for the presentation of the Standards Authority's qualitycertificate as a condition for export clearance where the buyer confirms his/heracceptance of a different specification, or internationally accepted standard,and his/her acceptance of certification of compliance by a party other than theStandards Authority has been waived.

E. IMPLEMENTATION ARRANGEMENTS

67. The Ministry of Finance will have responsibility for the overall management of ihereform program. The Minister of Finance coordinates a working group, which includes, inter aia,the Minister and representatives from MEDaC, the Ministry of Trade, the Federal Civil ServiceReform Commission, the Prime Minister's Office and the National Bank of Ethiopia. The grouphas been working closely with IDA and IMF staff in preparing the reform program and willcontinue to monitor its implementation. A number of technical committees, as detailed in thePolicy Matrix have been established to implement and monitor various aspects of the programand to facilitate Government-donors dialogue. IDA and other donors will provide technicalassistance for the implementation effort as needed. The preparation of the full PRSP is Ethiopia-led. The Govemment has established a Steering Committee at the Ministerial level to guide theprocess and a technical committee to organize the analytical work and the consultative process.The latter will involve consultations with the regions and municipalities, as well as with civilsociety and representatives of the development community, NGOs and multilateral and bilateralagencies.

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F. RISKS

68. Besides economic risks, already discussed, the Credit faces three other categories of risks.First is the possibility of resumption of hostilities with Eritrea. This risk is reduced by thedeployment of UN peace keeping troops which are monitoring the implementation of the peaceagreement; the creation of a border Temporary Security Zone, from which Ethiopia and Eritreahave withdrawn their troops; and the demobilization of the army, which is proceeding at a fasterrate than anticipated. In addition, for the current year the Government anticipates a furtherreduction of defense spending over the budgeted amount. Second, there is a significant risk ofdelays in the implementation of the reform program because of weak institutional capacity in boththe public and private sectors. This risk would be reduced by the financial and technicalassistance provided by the donor community. The Government has also asked for an increase inIDA assistance specifically in the area of capacity building. Finally, there is a risk of weakeninggovemment commitment. So far, the Government has shown its strong commitment to thereform program by implementing a number of reform actions in anticipation of the ERSC and byparallel efforts to strengthen public expenditure management to improve monetary management,and continue the financial sector reform.

IV. RECOMMENDATION

69, I am satisfied that the proposed Credit complies with the Articles of Agreement of theAssociation and recommend that the Executive Directors approve it.

James D. WolfensohnPresident

By:Shengman Zhang

Managing Director

Washington, D.C.April 30, 2001

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ANNEXES

Annex A: Policy MatrixAnnex B: Letter of Development PolicyAnnex C: Country at a GlanceAnnex D: Key Economic IndicatorsAnnex E: Key Exposure IndicatorsAnnex F: Balance of Payments, 1997-2003Annex G: Social IndicatorsAnnex H: Status of Bank Group OperationsAnnex I: Portfolio Improvement and Project Implementation

Policy MatrixGovernment's Policy Objectives and Implementation Benchmarks

Development ERSC Benchmarks . OutcomesObjectives/Issues . ._._.

Actions before Board Actions before end 2-Q01/02 Actions before end 2002103Presentation .

Macroeconomic stability, growth and poverty reductionFocus on Poverty Alleviation & * Prepare I-PRSP (Interim Poverty * Prepare full PRSP * Prepare progress report on * Articulated andGrowth Reduction Strategy Paper) PRSP budget costed* Over 45 percent of strategy for

population or 28 mnillion is poverty reductionpoor, 24 percent ofpopulation live in abjectpoverty

Recover of economic growth * Agreed macroeconomic framework * Satisfactory performance under agreed * Satisfactory performance * Macroeconomicand maintain macroeconomic macroeconornic framework under agreed macroeconomic stability andstability framework economic growth* Worsening of economic

situation in 1999/2000(shaip deterioration ofterms of trade, a severedrought and the conflictwith Eritrea)

* A Peace Agreement withEritrea was signed onDecember 12, 2000

Increase public spending to * Budget for 2000/01 provides for * Budget for 2001/02 to reflect increased * Budget for 2002/03 to reflect * Improved socialsocial sectors significant reallocation ofpublic allocation to poverty-targeted sectors increased allocation of public indicators* Low funding at the spending to poverty- targeted sectors from 12.1 percent ofGDP in 2000/01 to spending to poverty-targeted

regional level has (from 8.6 percent of GDP in 13.1 of GDP (after HIPC) sectors from 13.1 percent ofimpeded effective 1999/2000 to 12.1 percent in 2000/01) GDP in 2001/02 to 14 per centdelivery of health and * Executed public expenditure for of GDP in 2002/03 (aftereducation services poverty targeted sectors in 2000/01 HIPC); budget priorities

consistent with budget for 2000/01 consistent with PRSP

* Executed public expenditurefor poverty targeted sectors in2001/02 consistent with budget e

for 2001/02 >

Policy Matrix ot '>Government's Policy Objectives and Implementation Benchmarks

Devdeopxenit EiSC Bencmars u k t cois s

bectives Isues _______________ _______ ________

Ac tions beforeBoard Actions befotre.end dR21/2: At sionsbefore end 24 /0203* ~~~~~~~Presentation

Improve Understanding of * Launch of study to analyze poverty * Complete poverty study and impact * Improved

Poverty and Focus of Poverty incidence and trends using the new analysis of programs by end of 2001 understanding of

Programs 1999 Household Budget Survey poverty in

Processing of 1999 Ethiopia

household survey * Launch of work program for theunderway. Analysis of Welfare Monitoring Unit to analyzepoverty on the basis of the impact of Government policies1999 household survey, to and programs on the incomes of thefeed into PRSP poor _

Public Sector ManagementStrengthen the legal framework * Adoption of draft Civil Service Law * Subject to approval by Council of * Complete drafting of * Increased

and ethics architecture for the by Council of Ministers People's Representatives, institutional charters for all awareness among

federal civil service implementation of Civil Service Iaw federal ministries, departments, civil servants of

* A comprehensive Civil and agencies rights and

Service Refbom Program * Development of ethics training responsibilities(CSRP), launched in 1996, curriculum tbr federal civil servants * Undertake first phase of ethicsis ongoing at federal and training at the federal level * Greater citizen

regional level * Adoption by Council of Ministers of participation inCivil Service-wide Code of Conduct in monitoring

* A civil-service wide Code line with National Charter of Citizen's performance of

of Ethics is being prepared, Rights and Responsibilities ministries,in addition to the "National departments, and

Charter of Citizen's Rights agencies

and Responsibilities", thebasis for a modem ethicsarchitecture

Improve civil service pay and * Launch of diagnostic survey of Job * Adoption by Council of Ministers of * Implementation of medium- * Improved

remuneration Classification and Grading (JCG) medium-termn pay and employment term pay and employment incenitives for

* Inadequate pay for federal policy for federal civil service policy in federal govemment federal and

and regional civil servants * Completion of 1999 labor market consistent with the Macro-Economic and in the largest regions regional civil

has resulted in increasing survey on wage differentials and Fiscal Framework servants, greater

incidence of moonlighting, between private-public sector jobs retention of

poor work performance, qualified

and difficulties in retaining * Development of criteria for personnel

staff integrating fmdings from JCG andlabor market survey in view of

l___________________________ formulating a medium-term pay

Policy MatrixGovernment's Policy Objectives and Implementation Benchmarks

Development ERSC - Benchmarks OntcomesObjectivesA/ssues . - .

Atons before Board Actions before. end 21)01/02 Actions before end 21)02103________________ ._____ _ Presentation-

and employment policyImprove perfonmance of front- * Adoption by the Council of * Subject to approval by Council of * Publication of results of * Improvement inline service delivery Ministers of Draft National Policy People's Representatives, client report cards on all managerial

Govemment has on Service Delivery implementation of National Policy on participating federal practicesdeveloped a National Service Delivery institutionsService Delivery Policy topromote 'good practice' * Monitor client feedback using reportapproaches to improving cards in federal institutions piloting theagency perfonnance. national Policy on Service DeliveryThere is need to betterintegrate the Policy withGovernment's budgetprocess

Improve transparency of * Complete piloting of software for * Completion of automation of all * Installation of Wide Area * Increasedpersonnel management system. records and filing system as a personnel data for federal civil servants Network and roll-out of availability of* Government plans to prerequisite for the HRMIS and in Federal Civil Service Commission HRMIS across federal personnel data in

develop a Human Resource initiate roll out of the system across and federal line agencies institutions real-time acrossManagement Information federal line agencies federalSystem (HRMIS) that links * Establishment of an Inter-ministerial governmentall federal line agencies Technical Committee to develop IT institutions, and

policy for systems integration by July select regional2001 govemments

* Approval by Council of Ministers of * Establishment ofdraft IT policy networked

environment forfederal institutions

Public Expenditure Policy and ManagementImprove planning and budgeting * Establishment of a committee with * Adoption by council of ministers of * A review is made of the * A multiyearat the federal and regional levels membership from the Ministry of Macro-Economic and Fiscal implementation of MEFF and planning andto improve service delivery Economic Development and Framework (MEFF) and Public PIP for the budget of 2001/02. budgeting exercise

Cooperation (MEDaC) and Investment Program (PIP), satisfactory Based on this review they are is functional at theActions taken: Ministry of Finance (MoF) to, inter to IDA, leading to the budget for rolled over for the 2002/03 federal level* Regulations issued in 1997 aita, facilitate Government-donor 2002/03 by October 2001 and >

establishes a 3-year rolling dialogue on public expenditure submission to the Council of People's * Begin implementation of PEP toPublic Investment Plan issues Representatives by December 2001 at the federal level(PIP) o x

Policy MatrixGovernment's Policy Objectives and Implementation Benchmarks

Developmet ERSC Bench' krs Otoe

NAtons before Board Actionsbefore end l00 2 Actions before end 2002/03

A design document for a * The above committee will hold * Prepare any necessary legislation * Implementation of the actionPublic Expenditure semi-annual meetings with donors relating to the PEP and present it to the plan is under wayProgram (PEP) has been on public expenditure issues Council of People's Representatives forprepared for discussion approval

* MEDaC, in coordination with MoF toprepare plan that lays out the resourcerequirements and a timetable to help theregional states in carrying forward theirmulti-year planning and budgetingprocess

Improve predictability and * Adherence to the financial calendar (as * Review of the adherence to the * Predictable andtimely availability of funds by specified in the Budget Design Manual) Financial Calendar, and in timely availabilityadhering to a finn financial for the annual planning and budgetary particular its impact on of funds leads tocalendar cycle leading to the budget of 2002/03 improving the quality of improved planning

planning and budgeting at the and budgeting atActions taken: * Estimates of subsidies to the Regions regional and sub-regional level the regional level* A financial calendar has for the budget of 2002/03 are notified in

been outlined in the conformity with the financial calendar * Estimates of subsidies to thegovernment's Budget (January 9 - January 16, 2002) outlined Regions for the budget ofDesign Manual (Version in the Budget Reform Design Manual 2003/04 are notified in2. 1, February 2000). conformity with the financialPlanning starts in calendarSeptember and indicativeceilings are issued byJanuary

Effective public service delivery * Constitute a technical coordination * Outline plan of action for * Improvedthrough projects and programs committee with stafffrom MEDaC and implementing the PEP at the budgeting and

MoF to better integrate current and regional level and take steps to planning throughIntegrating capital and recurrent capital spending by June 2001 implement it better balancespending between capitalDiagnosis: and recurrent* Lack of effective expenditures

coordination betweenMEDaC and MoF in publicexpenditure planning andbudgeting

Policy MatrixGovernment's Policy Objectives and Implementation Benchmarks

Development ERSC Benchmarks Outcomes

Objectives/TssuesActions before Board Actions before end 2001/02 Actions before end 2002103

Presentation

Actions taken:* A design document for a

PEP - which whenimplemented will subsumethe PIP - has beenprepared for discussion

Improve timeliness of accounts * Provide to IDA an action plan to * Reduction in the backlog of accounts * Further reduction in backlog of * Reduction in the

preparation, reporting, and audit indicate progress and future plans for and audits from over 5 years to 3 years accounts and audits existing backlog

for increased transparency improving the accounting system, in of accounts

particular for reducing the cun-ent * Implementation of the reforn preparation,backlog of accounts preparation and program of the accounting reporting and auditreporting for audit system

* Action taken according to theaudit report after its submissionto the Council of Ministers

Inprove Financial Information * Agree with IDA on Action Plan to * Implementation of the findings of the * Review implementation of * An improved

Management System (FMIS) for develop an improved FMIS FMIS study FMIS, identify areas needing financial

efficient public expenditure further strengthening and management

management action plan for the same system

Strengthen Essential Social * Complete review of SDPs in * Reformulation of SDPs in Health and * Review of SPDs as part of * Improved

Services Education and in Health Education in line with PRSP priorities PRSP review education andhealth services

Sectoral DevelopmentPrograms (SDPs) in Healthand Education in need ofreformulation to takeaccount of affordability,and implementationcapacity _____

o A

Policy MatrixGovernment's Policy Objectives and Implementation Benchmarks _____

DevelopmntERSC Iechaks ~OutoeObjectives/Issues~~~~~~~~~~~~~~mr Ie

A~~tion5 before Board Actios before 4. 2001/0 Atons before ed2 202/03,

Presentation

Implementation * Report submitfted by Task Force to the * Adoption of recommendations to * Improvement ofbottlenecks at a regional MoF on issiplemnentation bottlenecks resolve bottlenecks for improving health andlevel have imipeded of SDPs (procurement, financial imnplementation of SDPs educationimplementation of SDPs management, monitoring and indicators as

reporting) indicated in the

]Private Sector Development and Export CompetitivenessIncrease private investment and * Sign contract witls consultants to * Begin implementation of action plan to * Improved andprivate sector participants initiate agreed study to identifyr implement study proposals simplified

regulations which hinder private regulatoryDiagnosis: sector development (study expected to fr-amework for

* Cumnbersome processes be completed by March 2002) private sectorand regulatoTy framework developmentfor private sectordevelopment _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

Put export promotion at the * Export Plromotion Council to * Export Promotion Council to continue * Export Promotion Council to * Feedback fromcenter of the political agenda reestablish its regular meetings to its regular meetings continue its regular meetings exporters and

provide a formn of discussion to export serviceActions taken: improve environment for exposts industry to Export* Creation of Export Promotion Agency

Promnotion Council chaired and Govemmentby Prime Minister

Imiprove access to imported * Adoption by Council of Ministers of * Prepare standard coefficients for * Assessment ofperformance of * Simplified accessinputs new Voucher-based Duty imnported inputs needed for most voucher- based duty exemption to duty-flee inputs

Exemption scheme, open to all common exports in order to facilitate scheme for exportActions taken: exporters with a genuine export the application of the voucher scheme production

* Duty drawback system order and to exporters usingintroduced and simplified Franco-valuta imports

Improve access to export finance * National Bank of Ethiopia (NBE) to * Export Credit Guarantee directive * Assessment of performance of * Improved accessissue Amended Directive on Export operational by July 2001 Export Credit Guarantee to credit for

Diagnosis: Credit Guarantee Scheme allowing Scheme and Suppliers Credit exporters;* Limnited access to export participating banks to charge * Suppliers Credit Directive to be increased export

finance prevented market interest rates, Imniting the extended to cover suppliers credit for activityexporters from expanding maximum collateral requested to inputs for the purpose of exports on abusiness beyond their new entrants and simplifying cash basisfiiariwal capacity eligibility criteria ______________________________________

Policy MatrixGovernment's Policy Objectives and Implementation Benchmarks

Development ERSC Benchmarks OutcomesObjectives/Issues , , ,,, ._-_-_-_, _,,_':.

Actions before Board Actions' befr end 2001/02 Actions: before end 200214)3. lt~~~~~resentation .,.--,

Actions taken: NBE to allow for automatic

Export Credit Guarantee registration, and drop debt/equity ratio

scheme introduced, yet not requirement for suppliers credit in

taken up by relation to exportsexporters/banks

Eliminate remaining ex-post * The coverage of NBE export price * Greater

price monitoring on exports monitoring will be restricted only to flexibility of

Actions taken: products where international prices exporters to

* Government eliminated ex- are available from recognized enter markets

ante price controls (except international sources with fierce price

for coffee), but ex-post competition

price controls remain for * Export price informationmany products responsibility to be shifted out of

NBE to the Export PromotionAgency

Last remaining export ban exists * Replace export ban on raw hides and * Greater marketing

for raw hides and skins skins with export duty flexibility forproducers of raw

Diagnosis: hides and skins

* Export ban on raw hidesand skins preventsexporters to benefit froman important export market

* Slow and cumbersome * The requirement for the * Prepare a study on the process of * Begin implementation of the * Simplified

customs regulation harm presentation of the Standards approving and clearing of export study customs

exporters Authority's quality certificate as a shipment procedures for

condition for export clearance exporters

where the buyer confirms his/heracceptance of a differentspecification, or internationallyaccepted standard, and his/heracceptance of certification ofcompliance by a party other thanthe Authority will be waived

Attract Foreign Investnent * Elimninate case by case screening of * Review minimum investment * Simphfied

investments and related investment requirement for foreign investment - :

Diagnosis: ___________________________________ licensing for investments not specified investors procedures o 4

Policy MatrixGovernment's Policy Objectives and Implementation Benchmarks

Develo 00 +pment E iERSC Benchm ks Outcomes

Ac tios before Bondd Actions before end 2001/02 02/03

Prese_O . .__

* Numerous restrictions in the Negatve Lists (four lists under

prevent Ethiopia from the Investment Code which specify thebenefiting from foreign areas of activity where private

direct investment investment is restricted)

Achions taken: * Eliminate minimum investment

* Introduction of Ethiopian requirement for 100 percent export

Investment Authority investments

* Review of InvestmentCode

Continue privatization of * Complete preparation for privatization * Bring to the point of sale at least 10 * EPA to complete the * Public sector

parastatals.; encourage private of 21 enterprises (i.e. compile all enterprises (between January 2001 and privatization program of 111 divestment from

sector participation in documentation necessary to send September 2001) state owned enterprises which private sector

infrastructure invitation to tender) had begun in 2000/01 activities

* Bring to the point of sale at least 40Actions taken: * Initiate preparation for privatization of enterprises between January 2001 and

* Government has 13 enterprises (i.e. select winning the end of the 2001/02, and complete

undertaken large scale bidders for preparation) preparation for privatization of at least

privatization program; 20 enterprisesremaining task is bringingto point of sale 111enterprises; to becompleted between2000/01 and 2002/03

Enhance regulatory framework * Allow foreign private sector * Implementation of study

for utility sectors, improving participation in the Ethiopian recommendations

transparency and competition Telecommunication Corporation

* Launch of study to examine therelevant regulatory framework in keypublic utilities (gas, electricity, water)

Improve the functioning of the * Recommend that each region establish * Greater

urban land market and maintain a Register of Land transparency of

available for investors (to include all land availability;

Diagnosis, charges an" righLt der CaLL l u f _Uve._ _ F tt. rf

Policy MatrixGovernment's Policy Objectives and Implementation Benchmarks

Developnient ERSC - OarloesObjectives/Issues

Actions before Board: Actionsbefore.en4 2001102 Actions before end 20,02/03Presentation

* Investors face a number of land fully investigated) land for potentialdifficulties with regard to * Recommend that regional governments investorsthe process of lease enter into negotiated arrangements withacquisition, price and private investors to develop industrialstructure of lease and use parksof land as collateral

* Review the Urban Lands LeaseProclamation (80/1993) to ensure thatbanks taking leases as collateral areable to realize the full value of thatcollateral at any time

Increase agricultural - Sign contract with the selected * Pending the results of the study, limit * Implementation of action plan * Ensureproductivity consulting firm to conduct agreed goverwnent's direct supply of inputs to competitive* Government established a study on fertilizer marketing and credit the Extension Intervention Program market in fertilizer

sound national fertilizer farmers to no more than two years imports andpolicy. However, the * Pending the results of the study, (three years in woredas where domesticmarketing of domestic Government will recommend to all alternative channels are not available) marketingfertilizer has been regional governments to procureprogressively reverting to a fertilizer for distribution under its * Prepare action plan based on thestate-controlled fertilizer extension programs only on the basis recommendations of the study onprocurement and of competitive bidding prcedures, as fertilizer marketing and credit; anddistribution system is already the practice in some regions time-table for implementation

* Growing mismatchbetween the decliningnumber of active fertilizerimporters and expandingfertilizer importrequirements

"^D 0

Annex BPage I ofr9

nA.+es P A2 tsnuhaeLn enlhb + .r1)fl1G '<WV:C Ref. NO.

The Federal Democratic Republic of Ethiopia +MiI'XSTRY OF FINANCE Date MIarch 23, 2001

MIr. James D. WolfensohnPresidentInternational Development Association1818 H Street, NWWashington DC 20433

Dear Mr. Wolfensohn.

LETTER OF DEVELOPMENT POLICY

1. I am writing to request, on behalf of the Government of the Federal Democratic Republicof Ethiopia, an Economic Rehabilitation and Support Credit (ERSC) of US$150 million from theInternational Development Association (IDA) in support of our poverty reduction and cconomicrecovery strategy. The proposed credit will support our efforts to stabilize the economy and moveback to a sustainable path of growth. This letter sets out the actions that the Government ofEthiopia will undertake over the short and medium term in order to implement its reformprogram, focusing on measures that will improve public sector management, enhance the directimpact of public expenditure on poverty reduction, and stimulate private sector development andexport competitiveness. I am attaching a policy matrix which we have prepared in collaborationwith the IDA team and which sets out the contents of this letter in summary form.

2. The Government is preparing a poverty reduction strategy paper (PRSP) in which it willarticulate more fully the specific policies that will be implemented to reduce poverty and achievethe International Development Goals by 2015. We expect to complete the full PRSP within thenext year, i.e. around March 2002, with the participation of the poor and in consultation with civilsociety, the private sector and development partners. As a step towards the full PRSP, we haveprepared an Interim PRSP (I-PRSP). The I-PRSP was discussed by the IMF and the IDA Boardsin March 2001. It was endorsed as a sound basis for the preparation of a full PRSP and for

MAb s52400 ,'.y* 4. NMAM h AFt*7Ted. 65 20 14 P.O.Box 1905 Faz SS 13 5 5 Ababa Etfi

Annex BPage 2 of 9

obtaining concessional assistance from the IDA and the IMF. Apart from the timeline and processfor preparing the full PRSP, the I-PRSP also spells out our objectives for promoting povertyreduction and equitable growth.

3. The reform program for the ERSC is based on the objectives described in the I-PRS P.The ERSC has an important bridging function. It provides interim support until follow onoperations can be requested on the basis of our medium and long term reform program of povertyreduction which is being elaborated in the full PRSP. For the prioritization process in the attachodPolicy Matrix we have concentrated, in conformity with this timetable, on short term measuresthat are critical to our reform program. These measures are therefore proposed as specificmilestones for the ERSC. The remaining actions for 2001/2002 and 2002/2003 indicate our bestcurrent estimate of measures that will be at the core of our poverty reduction strategy.

Background and Recent Developments

4. Poverty in Ethiopia: During the 1990s, Ethiopia has made progress in increasing growthand reducing poverty. However, it remains one of the poorest countries in the world: 47 percelntof its rural population and 33 percent of its urban population count as poor. Our per capita incormieof US$100 is among the lowest of the least-developed countries, and reliance on agriculture isamong the highest in the group. Socio-economic indicators in Ethiopia are also among the worstworldwide, reflecting widespread poverty: life expectancy at birth is only 43 years, 47 percent ofchildren under five are malnourished, the illiteracy rate is 63 percent and gross primaryenrollment is 43 percent; all these figures are worse than the sub-Saharan average.

5. In 1999/2000 our economic situation deteriorated because of severe drought conditions, a22 percent decline in the terms of trade - reflecting a sharp drop of coffee export prices and asteep rise in petroleum import prices - and the impact of a border conflict with Eritrea which haderupted in 1998. Thanks to large food grants by donors and government purchases of grain insurplus areas a catastrophe in the drought stricken areas could be avoided. Nevertheless, ourexternal position worsened, and official reserves declined to two months of import cover. InDecember 2000 we signed a peace agreement with Eritrea, thus ending a two year long conflict.In March 2001 the IMF Board approved a three-year arrangement under a Poverty Reduction andGrowth Facility (PRGF). However, our external economic position will remain vulnerable duringthe current year because of lower than expected coffee prices and an anticipated 30 percent fall incoffee production. Simulations show that a further deterioration in the terms of trade may provedisruptive, and would exacerbate poverty in our country.

6. The ERSC will provide essential funds to: sustain the economic recovery; restore keyeconomic and social services; reduce the domestic financing of the deficit and re-build foreignexchange reserves; and finance the surge in private sector imports associated with the recentelimination of restrictions in the foreign exchange market.

7. Against the background of pervasive poverty in Ethiopia, the overriding objective of ourpolicy is to achieve sustainable equitable growth and poverty reduction. Central to tileachievement of this objective is the implementation of a long-term strategy of agricultural-development-led industrialization (ADLI), aimed at stimulating a rise in incomes in rural areas,where 83 percent of the Ethiopian population lives, and at inducing industrialization in urbanareas. The ADLI strategy has recently been reviewed and reconfirmed through a wide process ofconsultations and forms the basis of the National Development Strategy, and the five yearNational Development Program (NDP, 2000/01-2004/05). The NDP has guided the preparationof our Interim Poverty Reduction Strategy (I-PRSP).

Annex BPage 3 of 9

8. With the end of the war, we now face the challenge of demobilizing the army,reconstructing damnaged infrastructure and key public services, stimulating private sectordevelopment and regaining investor confidence. We would like to express our appreciation of thesupport IDA is providing us to overcome the negative economic and social impact of the war,under its Interim Support Strategy of December 2000.

9. Within a context of peace and macroeconomic stability, Government now wishes toaccelerate the economic recovery and the reduction of poverty. To this aim, it wishes to improveadministrative efficiency and the delivery of public services by implementing a public sectormanagement reform and expenditure strengthening; and to increase the employment opportunitiesfor the poor by accelerating private sector reforms. The ERSC that we are requesting from IDAwill support the initial round of reforms in these areas and the economic recovery. The reformprogram outlined below will help to ensure the success of our program.

The Reform Program

10. Our medium term strategy for growth and poverty reduction - laid out in the I-PRSP - isbased on four pillars: (i) raising rural incomes through increased agricultural productivity andimproved conditions for the non-farming economy; (ii) removing impediments to private sectoractivity, reducing the role of the state in the economy and accelerating export growth; (iii)reforming the judiciary and the civil service to improve effectiveness and accountability andstrengthening public expenditure policy and management; and (iv) increasing the quality of lifeof the poor through the decentralized provision of primary health care, education, water andsanitation services.

11. This strategy is supported by a macroeconomic framework which aims at maintainingmacroeconomic stability and promoting the recovery of growth. The 2000/01 - 2002/03 programis supported by a PRGF arrangement with the IMF. We are also currently seeking assistanceunder the Enhanced Initiative for HIPC to reduce the external debt burden to a sustainable level,and where we hope to reach the decision point in the near future.

12. Funding provided by the ERSC will support the continuation of a stable macro-economicframework, and the reallocation of public expenditure from defense to poverty-targeted sectors(education, health, agriculture, natural resources and roads). Funds expected from the HIPCinitiative (including the interim support) will be allocated to these sectors. Expenditures would beexecuted through the re-defined and improved sectoral development programs. The currentbudget already includes a significant increase in spending allocated to poverty-targeted sectors(from 8.6 percent of GDP in 1999/2000 to 12.1 percent in 2000/2001). Even further, weanticipate an additional reduction of defense spending over the budgeted amount which will allowadditional expenditure to be reallocated to poverty-targeted sectors. Consistent with the PRSPobjectives, the budgets for 2001/2002 and 2002/2003 will reflect further increases to 13.1 percentof GDP (after HIPC) and 14 percent of GDP (after HIPC) respectively. The Government willalso ensure that executed public expenditure for poverty targeted sectors will be consistent withbudgetary allocations. In preparing the PRSP, the Government has launched a study to analyzepoverty incidence and trends using the new 1999 Household Budget Survey; and it has started awork program (which will be implemented in the Welfare Monitoring Unit) to analyze theimpact of Government policies and programs on the incomes of the poor. Both studies will becompleted during next fiscal year.

Annex BPage 4 of 9

13. In addition to the macroeconomic program, the ERSC will support policy reforms andimprovements in the following three areas: (i) Public Sector Management; (ii) Public ExpendituirePolicy and Management, and (iii) Private Sector Development and Export Competitiveness.

Public Sector Management

14. Civil Service Reform Program. In 1996, we launched the Civil Service ReformProgram (CSRP) as part of an overall effort to build a transparent, efficient, and ethical CivilService, that would meet our standards for improved governance. We find that the process ofdecentralization offers civil servants opportunities to be more responsive to local needs butdemands much more in terms of front-line service delivery performance, client-orientation, nmdcapacity. There is a need to develop arrangements that place a premium on improved sen icedelivery and client orientation; and to address incentive problems, primarily caused by inadequateremuneration. The role of the federal Government, particularly in areas of national interest suchas policymaking, standards setting, and monitoring, requires greater clarification as regionalauthorities take on the bulk of responsibility for the delivery of essential services. The five ma.jorSub-Programs of the CSRP comprise: (i) Expenditure Control and Management; (ii) HunmLanResource Management; (iii) Service Delivery and Quality of Service; (iv) Top ManagementSystems; and (v) Ethics. While the Program is comprehensive in scope, implementation ]haslagged in the last two years because of the effects of the war, and lack of implementationcapacity. Strengthening the civil service is now a high priority for the Government as we seek tocarry out the ambitious development strategy articulated in the I-PRSP.

15. Elements of a renewed implementation strategy for the CSRP over the short- to medium-run include: (i) establishing the legal framework and ethics infrastructure for a modem civilservice; (ii) improving service delivery performance; (iii) creating an enabling environment forcivil servants by improving pay and remuneration; and (iv) enhancing the transparency ofpersonnel management systems. Progress has been made in these four areas, which build on theHuman Resources Management (HRM), Service Delivery and Quality of Service, and EthicsSub-Programs of the Government's CSRP. Annual Public Expenditure Reviews (PERs),conducted jointly by the Government, IDA and other donors, have increasingly focused on theinstitutional constraints that hinder effective policy and program implementation at the federaland regional levels. We expect that a successful implementation of the reforms will make aqualitative change in governance, transparency and accountability within the public sector.

16. Public Sector Management - Recent Actions: A number of regulatory measures wererecently taken to reform and enhance public sector management in preparation of the ERSC. Inparticular the Council of Ministers has adopted the draft Civil Service Law which provides abroad framework for a modern and efficient civil service, drawing on international goodpractices. The Council of Ministers has also adopted the draft National Policy on ServiceDelivery to improve the management and client-orientation of institutions involved in thedelivery of public services. We have also launched a diagnostic survey of job classification andgrading (JCG); completed and presented the 1999 labor market survey on wage differentialsbetween pnrvate-public sector jobs, and developed criteria for integrating findings from JCG andlabor market survey in view of formulating a medium-term pay and employment policy. Finally,we have completed piloting of a software for records and filing system, as a pre-requisite for theHuman Resources Management Information System (HRMIS), and initiated the roll out of thesystem across federal line agencies.

17. Before the end of 2001/2002, we are planning to undertake a number of measures in thearea of Public Sector Management. Subject to approval by the Council of People's

Annex BPage 5 of 9

Representatives we will implement the Civil Service Law and the National Policy on ServiceDelivery. The Council of Ministers will also adopt the Civil Service-wide Code of Conduct inline with the National Charter of Citizen's Rights and Responsibilities which will provide for thestrengthening of accountability relationships between government institutions and public at large.The Council of Ministers will also adopt a medium-term pay and employment policy for federalcivil service consistent with the Macro-economic and Fiscal Framework. Furthermore, we willdevelop an ethics training curriculum for federal civil servants, and monitor client feedback usingreport cards in federal institutions piloting the national Policy on Service Delivery. We willcomplete the automation of all personnel data for federal civil servants in the Federal CivilService Commission and federal line agencies. Finally, after having established an Inter-ministerial Technical Committee to develop an Information and Technology (IT) policy forsystems integration by July 2001, a draft IT policy will be adopted by the Council of Ministers.

18. Further actions are planned during the 2002/2003: It is envisaged that we willimplement the medium-term pay and employment policy in federal government and in the largestregion, and undertake the first phase of ethics training at the federal level. We will also completedrafting of the institutional charters for all federal ministries, department and agencies, andpublicize the results of client report cards for all participating federal institutions. Finally, we willinstall the Wide Area Network and roll-out HRMIS across federal institutions.

Public Expenditure Policy and Management

19. Public Expenditure Policy and Management Reform Strategy. The main objective ofthe reform of the public expenditure system is to enhance its accountability and effectiveness.Our public finance management system is disciplined and spending is in compliance withbudgeted allocations. Budget allocations are honored by the MoF and the regional financebureaus, and are adhered to by the spending agencies as hard budget constraints. While there arebottlenecks in timely reporting of expenditures at the regional level and below, generally thevariations between the budget allocations and actual outcomes are minimal. Nevertheless, thereis scope for improving linkages between planning, policy and budgetary allocations; forintegrating capital and recurrent budgets; and for improving preparation of accounts and thenaudits. The overarching framework of the reform strategy is detailed in the ExpenditureManagement & Control (EMCP) Sub-Program of the CSRP. The resource management strategyis also reflected in our I-PRSP and will be supported by the ERSC and follow-on operations.

20. Public Expenditure Policy and Management - Recent Actions: In preparation for theERSC, we have undertaken the following measures: we have established and made operational acommittee consisting of staff from the Ministry of Economic Development and Cooperation(MEDaC) the Ministry of Finance (MoF) to facilitate, inter alia, Government-donor dialogue onpublic expenditure issues. This committee will hold semi-annual meetings with the donors onpublic expenditure issues. We have also provided IDA with an action plan to indicate progressand future plans for improving the accounting system, in particular for reducing the currentbacklog of accounts preparation and reporting for audit, and we have agreed with IDA on anAction Plan to develop an improved Financial Information Management System (FMIS). Asregards social sectors, we have completed reviews of the Sectoral Development Programs (SDPs)in Education and Health, and a Task Force has submitted a report on implementation bottlenecksof the SDPs (procurement, financing management, monitoring and reporting).

21. Before the end of 2001/2002, we are planning to undertake the following measures: ByOctober 2001, the Council of Ministers will adopt a Macro-Economic and Fiscal Framework(MEFF) and a Public Investment Program (PIP), which will lead to the budget for 2001/2002, and

Annex BPage 6 of 9

2002/2003 and by December 2001 it will submit it to the Council of People's RepresentativesWe will also prepare any necessary legislation relating to the PEP and present it to the Council of"People's Representatives for approval. Furthermore, MEDaC, in coordination with the MoF will.prepare a plan that lays out the resource requirements and a timetable to help the regional states ir,carrying forward their multi-year planning and budgeting process. We will also adhere to thefinancial calendar (as specified in the Budget Design Manual) for the annual planning an/lbudgetary cycle leading to the budget of 2002/2003, and notify Regions of estimated subsidies forthe budget of 2002/2003 in conformity with the financial calendar (January 9 - January 16, 20021outlined in the Budget Reform Design Manual. We will reduce the backlog of accounts and auditsfrom over 5 years to 3 years. In addition we will constitute a technical coordination committeewith staff from MEDaC and MoF to better integrate current and capital spending by June 2001,and prepare an action plan for the implementation of the findings of the FMIS study. Finally, weplan to complete and adopt an Action Plan to reformulate the sector development Programs(SDPs) in Health and Education in line with PRSP priorities, and resolve the bottlenecks fcrimproving implementation of SDPs.

22. The following actions are planned during 2002/2003: we will review theimplementation of the MEFF and Public Investment Plan (PIP) for the budget of 2001/2002. Onthe basis of this review, they will be rolled over for the 2002/2003 period. We will also review th eadherence to the Financial Calendar and in particular its impact on improving the quality ofplanning and budgeting at the regional and sub-regional level; the implementation of the FMIS toidentify areas in need of further strengthening and prepare an action plan accordingly; and theSPDs as part of the PRSP review process. We will also begin the implementation of the PublicExpenditure Plan (PEP) at the federal level, and outline a plan of action for implementing thePEP at the regional level, and take steps to implement it. We will again timely notify Regions ofestimates for subsidies for the budget of 2003/2004. As regards accounts and audits, we willcontinue implementing the reform program, further reduce the backlog of accounts and audits,and take action according to the audit report after its submission to the Council of Ministers.

Private Sector Development and Export Competitiveness

23. Private Sector Development: Our economic growth strategy rests on ADLI, and theindustrialization part of it is inter-woven with the development of a strong private sector. Thecountry has shifted from a socialist to a market economy and many elements for a take-off of theprivate sector are already in place. These include macroeconomic stability, market liberalizationand expansion of the education sector. As a results of our reform program, we expect the privatesector to grow significantly in the medium termn. Partly, such growth will result from existinginvestment projects in the infrastructure and manufacturing sectors. More importantly, however,is an expected increase in industrial investment. To stimulate private sector growth, we willconcentrate on measures in three areas: (i) identifying and eliminating regulatory constraints, an-dimproving administrative implementation capacity; (ii) encouraging public-private sectorpartnerships and dialogue; and (iii) improving the business environment and investment climate.The measures supporting the ERSC mainly address the first area; measures envisaged for themedium term address the second and the third areas.

24. Export Orientation: The ADLI strategy recognizes the critical role of exports, both interms of income growth and foreign exchange generation. Furthermore, ADLI provides for aprogressive integration into the global economy. Therefore, we see export orientation and ADLIas mutually reinforcing. The importance attached to export growth is reflected in the formulationof an export strategy in 1998, and the establishment of the Export Promotion Agency in the samneyear.

Annex BPage 7 of 9

25. Private Sector Development and Export Competitiveness - We have identified thefollowing as constraints for private sector development: (i) regulatory constraints, (ii) low shareof exports in GDP and little diversification of exports, (iii) incomplete privatization program, (iv)no efficient fertilizer market, (v) limited private sector participation in infrastructure, (vi) entrybarriers for foreign direct investment (FDI). Regulatory constraints impose high transaction costson business operations and discourage investment. Export diversification has been disappointing,although a number of policy improvements have been made in several key areas in recent years:elimination of ex-ante price verification for all exports, except coffee, simplification ofprocedures for non-equity collaboration with foreign firms; introduction of a duty draw-backsystem; and an Export Guarantee Scheme. A temporary 10 percent surcharge on imports wasdropped in the current fiscal year, thus reducing average tariff rates to 19.5 percent. Ethiopia is inthe midst of the second phase of an ambitious privatization program that began in March 1995.Since 1995, 166 state owned enterprises (SOEs) were sold, mostly retail outlets, restaurants andsmall scale firms. The privatization process is well organized, and conducted in an open andcompetitive framework. The current privatization phase involves enterprises that are larger and inkey industrial sectors (e.g. leather industry, textiles, construction, mining, agricultural industry).The Ethiopian Privatization Agency (EPA) is planning to bring to the point of sale 111 SOEs, by2002/2003, thus completing the program of privatization in the agriculture and industrial sectors.

26. A number of other issues are important to private sector development. In agriculture, anefficient fertilizer market, which is a crucial condition for increasing yields, has so far failed tomaterialize. Private participation in infrastructure (PPI) continues to face significant obstacles.Much remains to be done to increase competition in service provision. So far, privateparticipation has been piecemeal (a few years ago, a decision was taken to allow privateparticipation in power and telecommunications). Various entry barriers (cumbersomeadministrative processes, regulations conditioning FDI) still represent an important obstacle toattracting foreign investment. Furthermore, institutional weaknesses are hindering thedevelopment of an efficient land market and the use of land as collateral.

27. Private Sector Development and Export Competitiveness - Recent Actions: TheCouncil of Ministers has adopted a new Voucher-based Duty Exemption Scheme, recommendedby the Board of Export Promotion Agency. The scheme is open to all exporters with a genuineexport order and to exporters using Franco-Valuta imports. The National Bank of Ethiopia (NBE)has issued an amended directive on the Export Credit Guarantee Scheme allowing participatingbanks to charge market interest rates, limiting the maximum collateral requested to new entrantsand simplifying eligibility criteria. NBE's price monitoring coverage has been restricted to onlyproducts where international prices are available from recognized international sources; and theexport price information responsibility has been shifted to the Export Promotion Agency. Wehave also waived the requirement for the presentation of the Standards Authority's qualitycertificate as a condition for export clearance where the buyer confirms his/her acceptance of adifferent specification or intemationally accepted standard, and his/her acceptance of certificationof compliance by a party other than the Authority. As far as analytical work is concerned, wehave signed a contract with consultants to initiate a study agreed with IDA to identify regulationswhich hinder private sector development; we expect the study to be completed by March 2002.Furthermore, we have signed the contract with the selected consulting firm to conduct a studyagreed with IDA on fertilizer marketing and credit. As regards fertilizer, pending the results ofthe study, we have recommended to all regional governments to procure fertilizer for distributionunder the extension programs only on the basis of competitive bidding procedures, as it is alreadythe practice in some regions. We have also continued our privatization program by completingthe preparation for privatization of 21 enterprises (i.e. we have compiled all documentation

Annex BPage 8 of 9

necessary to send out the invitation to tender), and selected the winning bidders for thepreparation of 13 enterprises. Finally, the Export Promotion Council, normally chaired by thePrime Minister, has resumed its regular meetings to provide a forum of discussion to improve theenvironment for exports.

28. Before the end of 2001/2002, we are planning to undertake a number of important policymeasures. Regulatory reforms will include making the changed Export Credit Guarantee directiveoperational early in the financial year. We will also prepare standard coefficients for importedinputs needed for most common exports in order to facilitate the application of the voucherscheme. The Suppliers Credit directive will be extended to cover suppliers credit for inputs forthe purpose of exports on a cash basis; the NBE will allow for automatic registration, and dropthe debt/equity ratio requirement for suppliers credit in relation to exports. Furthermore, theUrban Land Lease Proclamation (80/1993) will be reviewed to ensure that banks taking leases ascollateral are able to realize the full value of that collateral at any time. As far as foreigrinvestment is concerned, we will eliminate case by case screening of foreign investment notspecified in the Negative Lists (four lists under the Investment Code which specify the areas ofactivity where private investment is restricted), and eliminate the minimum investment:requirement for 100 percent export investments. We will allow private sector participation in theEthiopian Telecommunication Corporation. We will continue the privatization program b)bringing to the point of sale at least 40 additional enterprises (of which ten enterprises beforeSeptember 2001) and complete preparation for privatization of at least 20 enterprises. We willprepare a study to examine the relevant regulatory framework in key public utilities (gas,electricity, water), and one on the process of approving and clearing of export shipment. We willalso begin to implement the action plan derived from the private sector study, and prepare anaction plan based on the recommendation of the fertilizer study; these findings will also be sharedwith IDA. As regards land availability, we will recommend to each region to establish andmaintain a Register of Land available for investors (to include all charges and rights over eachparcel of land fully investigated), and to enter into negotiated arrangements with private investorsto develop industrial parks. Finally, pending the result of the fertilizer study we will limitgovernment's direct supply of inputs to the Extension Intervention Program farmers to no morethan two years (three years in woredas where alternative channels are not available). We willalso replace the export ban on raw hides and skins with an export duty.

29. Further actions are planned under the ERSC during 2002/2003: We will assess thoperformance of the Voucher Based Duty Exemption Scheme, the performance of the ExportCredit Guarantee Scheme, and of the Suppliers Credit. We will further review the minimun-investment requirement for foreign investors. EPA will complete the privatization program of Il l state owned enterprises which begun in 2000/2001. We will also begin implementation of thcrecommendations from the study on export shipment; the study on the regulatory framework ofthe utilities, and the action plan based on the fertilizer study.

30. Actions taken in the preparation of the ERSC and planned for the future represent asignificant progress in an ongoing process of regulatory improvement, and of a reduction in therole of the State in the economy, and in ensuring an acceleration of exports. A policy frameworkfor addressing the remaining issues, including constraints for FDI, urban land lease market andprivate participation in infrastructure, will be fully developed in the context of the PRSP.

Annex BPage 9 of 9

Conclusions

31. I would like to take this opportunity to reiterate our commitment to the implementation ofthe poverty reduction strategy spelled out in the I-PRSP and the actions to be undertaken in theshort and medium term under the reform program outlined above, focusing on measures whichimprove public sector management, strengthen public expenditure policy and management, andstimulate private sector development and export competitiveness.

32. Within a context of peace and macroeconomic stability, the Credt will help to bringabout a sustained economic recovery and accelerate the reduction of poverty. Public sectormanagement and expenditure strengthening will increase administrative efficiency, and improvethe delivery of public services. Private sector reforms will spur growth and create employmentopportunities for the poor, particularly in agriculture and in the export sectors. We hope that IDAwill continue to support our program of poverty reduction with follow up operations based on thePRSP.

33. On behalf of the Government of the Federal Democratic Republic of Ethiopia, I wish tothank the IDA for the assistance already provided under the "Interim Support Strategy". I trustthat this request for additional assistance through the proposed ERSC will receive your favorableconsideration.

Yours sinqe4ely,

.... . -/ - ----

H.E. At Sahmed, Minister of Finance,Fedey- emocratic Republic of Ethiopia

;/1

Annex CPage 1 of 2

Country at a Glance

Sub-POVERTY and SOCIAL Saharan Low-

Ethiopia Africa incomne Development diamond'

11999Population, mid-year (millions) 62 8 627 3 3,536.4 Life expectancyGNP per capita (Atlas method, US$) 100 510 520GNP (Atlas method, US$ billions) 6.5 323 1,842

Average annual growth, 1993-99

Population (Y.) 2.3 2.2 1.4Labor force (°X) 2 3 2 2 1 4 GNP Gross

per primaryMost recen+t estimate (latest year available, 1993-99) capita enrollment

Poverty (% of population below national poverty line) 46Urban population (% oftotalpopulation) 17 34 31Life expectancy at birth (years) 43 50 60Infant mortality (per 1,000 live births) 97 92 77Child malnutrition (% of children under 5) 47 32 43 Access to safe waterAccess to improved water source (% of population) 30 43 64Illiteracy (% of population age 15+) 63 39 39Gross primary enrollment (%of'school-agepopulation) 43 78 96 ' Ethiopia

Male 55 65 102 Low-income groupFemale 31 71 86

KEY ECONOMIC RATIOS and LONG-TERM TRENDS

1979 1989 1998 1999 iEconomic ratios*

GDP (USS billions) . 81 6.6 6.4

GrossdomesticinvestmentUGDP . 135 15.1 14.8Exports of goods and services/GDP . 9.2 158 142 TradeGross domestic savings/GDP .. 7 9 5 7 -0 1Gross national savings/GDP . 9.8 100 3.7

Current account balance/GDP -3.6 -5.1 -11 0Interest payments/GDP 0.9 1 3 1 3 Domestic InvestmentTotal debt/GDP - 96.8 78 4 82 8 SavingsTotal debt service/exports 6.2 40.2 57 7 63 3Present value of debt/GDP . 120.6 45.6Presentvalueof debt/exports . . 7464 311 1

Indebtedness1979-89 1989-99 1998 1999 1999-03

(average annual growth)

GDP 0.9 41 -1 4 6.2 6.6 EthiopiaGNP per capita -1.9 08 -3.3 38 41 Low-income groupExports of goods and services 2.8 6.4 -9.7 -2 6 99

STRUCTURE of the ECONOMY

1979 1989 1998 1999 |Growth of investment and GDP (%)(% of GDP) "IHO-Agriculture 485 52 3 52 3 soIndustry . 14.2 11.1 11.1 4

Manufacturing . 8.5 70 70 40

Services . 37.3 36.5 36 5 -

Private consumption 73.5 80.1 82.0 -20 9 9 9 97 asGeneral government consumption . 18.7 142 18.2 - GDI -- *-GDPImports of goods and services 14.8 252 29 1

1979-89 1989-99 1998 1999 Growth of exports and imports I%)(average annual growth)Agrculture -0.4 2.4 -108 38

155 TIndustry 1.2 42 09 69 r K

Manufactunng -0.9 42 -3.5 7 0 so 3Services 2 8 5.8 10.4 8.5 40

Private consumption -0 3 3 4 0 0 5.5 20'General government consumpbon 4.4 3 2 30 7 32 3 oGross domestic investment 3.4 8.3 -12.6 41 20 -Expor 5 s -'-ImportsImports of goods and services 25 3.9 9.9 18.4 exporls rnportsGross national product 07 4.1 -0 9 64

The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond willbe incomplete.

**Current account babnce excludes official capital transfers.

Annex CPage 2 of 2

PRICES and GOVERNMENT FINANCE1979 1989 1998 1999 Inflation(%)

Dornestic pnces(% change)Consumerprices 160 96 3.6 3.9 c Implicit GDP deflator 4.3 10 1 1.3 5

Govemrment rinance g(% of GOP, includes cun-ent grants) -5 5 S 94Current revenue .. 23.2 18.0 17.9 -10Current budget balance 0.6 2.3 -3.0 - GDP deflator CPlOverall surplus/deficit -6.2 -4.3 -8.5

TRADE1979 1989 1998 1999 Export and import levels (USS mill.)

(US$ millions)Merchandeie exports (fob) 360 444 602 484 sso-

Coffee . 303 420 281 1,800Hides 60 51 32 1.400Manufactures .. .

Merchandrze imports (cif) 589 1,020 1,357 1,558 8s*Food 186 28 100 600Fuel and energy 103 14 611Capital goods 397 582 643

Export price index (1995=100) . 82 94 78 93 94 9S 96 97 98 9Import price index (1995=100) .. 117 95 92 rIExports *lmportsTerms of trade (1995=100) .. 70 99 84

BALANCE of PAYMENTS1979 1989 1998 1999 Current account balance to GDP (%)

(US$ millions)Exports of goods and services 455 752 1,037 914 oIrnports of goods and services 660 1,201 1,653 1,873 2Resource balance -205 -449 -616 960

Net income -3 -83 -66 -52Net current transfers 83 238 349 302 -e

Current account balance -124 -294 -333 -709 -e

Financing items (net) 79 284 311 688 -1.Changes in net reserves 45 10 22 21 12

Memo:Reserves including gold (USS millions) 319 123 412 434Conversion rate (DEC, locaYUSS) 2.1 2.1 6.9 7.5

EXTERNAL DEBT and RESOURCE FLOWS1979 1989 1998 1999

(US$ millions) Composition of 1999 debt (US$ m il.)Total debt outstanding and disbursed 740 7,842 9,812 9,286

lBRD 59 31 0 0 G: 619IDA 221 718 1,586 1,948 F: 333 _:B1.948

Total debt service 29 304 561 585IBRD 9 13 0 0IDA 2 9 28 31 C: 127

Composition of net resource flowsOfficial grants .. .. 418Official creditors 95 402 -344 -274 1,532Private creditors 6 -70 -6 -7Foreign direct investment . 4 136 E - 2Portfolio equity .. 0

World Bank programCommitments 0 72 609 160 A -IRD E-BilateralDisbursements 47 70 72 148 8 - IDA 0- Other multilateral F - PrivatePrincipalrepayments 4 14 17 19 C-IMF G-Short-termNet flows 43 56 56 129Interest payments 7 8 11 12Net transfers 36 48 44 117

Note: Overall deficit (on a cash basis) includes grants and excludes prvatization receipts.Source: World Bank database

Annex DPage 1 of 2

Key Economic IndicatorsActual Estimate Prnj ected

Indicator 1997 1998 1999 2000 2001 2002 2003National accounts (percent of GDP at factor cost)Gross domestic producta 100 100 100 100 100 100 100

Agriculture 52 52 52 52 52 52 52Industry 11 11 11 11 11 11 11Services 37 37 37 37 37 37 37

Total Consumption 92 94 100 105 99 97 95Gross domestic fixed investment 17 15 15 12 17 19 20

Govemment investment 8 7 7 5 9 11 11Private investment 9 8 7 7 8 8 9

Exports (GNFS)b 16 16 14 16 15 16 16Imports (GNFS) 25 25 29 32 32 32 31

Gross domestic savings 8 6 0 -5 1 3 5

Gross national savingsC 10 10 4 3 9 11 12

Memorandum itemsGross domestic product 6383 6564 6439 6301 6452 6747 7327(USS million at current prices)GNP per capita (US$, Atlas method) 110 100 100 ..

Real annual growth rates (%)Gross domestic product at market prices 5.2 -1.4 6.2 4.6 7.8 7.0 6.4Gross Domestic Income 4.4 0.7 5.6 2.6 6.8 7.2 6.6

Real annual per capita growth rates (%)Gross domestic product at market prices 2.5 -3.8 3.6 2.2 5.5 4.7 3.0Total consumpbion 1.2 1.5 7.4 3.2 -2.4 2.0 1.6Private consumption -0.1 -2.5 3.0 -2.1 1.4 5.7 0.7

Balance of Payments (USS millions)Exports (good and nonfactor services) 1011 1037 914 977 990 1059 1161

Merchandise FOB 599 602 484 489 476 529 600

Imports (GNFS) 1589 1653 1873 2047 2046 2131 2241Merchandise FOB 1309 1357 1558 1735 1723 1787 1877

Resource balance -578 -616 -960 -1070 -1056 -1072 -1081Net current transfers 259 349 302 537 574 539 552Current account balance -417 -333 -709 -601 -534 -571 -557

Financing items (net) 261 311 688 395 634 757 682Change in reseTvesd 156 22 21 206 -100 -186 -125

Memorandum itemsResource balance (% of GDP) -9.1 -9.4 -14.9 -17.0 -16.4 -15.9 -14.7Real annual growth rates (%)Merchandise exports (FOB) 36.1 -9.7 -2.6 23.6 7.2 6.7 6.4

Primary 50.6 -26.0 -3.0 20.3 4.0 7.6 6.6Merchandise imports (CIF) 18A 9.9 18.4 6.3 -3.5 4.8 4.9

Annex DPage 2 of 2

Key Economic IndicatorsActual Fstimate Projeeted

Indieator 1997 1998 1999 2000 2001 2002 2003

Public finance (as % of GDP at market prices)Current revenues 18.2 18.0 17.9 18.4 18.8 19.0 19.(Current expenditures 13.8 15.7 20.9 26.0 21.5 18.9 17.4Capital expenditure 10.4 9.4 9.1 6.7 9.6 10.1 10. SExpenditure on Special Programs 0.0 0.0 0.0 0.0 1.9 3.4 1.1Foreign financing 5.4 4.6 6.4 4.4 13.0 13.1 lo.:

Monetary indicatorsfM2/GDP 39.8 41.3 40.7 43.7 43.8 43.6 43.1hGrowth of M2 (%) 3.4 12.7 5.9 14.0 12.5 13.2 10.6Private sectorcredit growth 1097.6 67.8 46.2 15.9 110.2 131.9 123.!total credit growth (%)

Price indices (YR81 =100)Merchandise export price index 97.4 108.4 89.5 73.2 66.4 69.2 73. Merchandise import price index 100.0 94.3 91.5 95.8 98.6 97.6 97.7Merchandise terms of trade index 97.3 115.0 97.9 76.4 67.4 70.9 75.5Real exchange rate (US$/LCU) g 38.7 38.7 38.1 ..

Consumer price index (% change) -6.4 3.6 3.9 4.2 5.2 4.9 2.1CTGDPdeflator(%change) 3 9 10 1 13 1 3 4-3 6-2 3.9

a GDP at factor cost. Data on sectoral decomposition unavailable. Constant shares used

b. "GNFS' denotes "goods and nonfactor services."

c Includes net unrequited transfers excluding official capital grants

d Includes use of IMF resources.

-. Consolidated central government. The Special Programs are for demobilization and reconstruction

f Monetary data as at July 7 of year shown.

g. "LCU" denotes "local cueTency units." An increase in US$!ILCU denotes appreciaton.

Source: Government of Ethiopia and Staffestimates.

Annex E

Key Exposure IndicatorsActual Fstimrate PrPiected

Indiamor 1997 1998 1999 000) 2001 2002 92003

Total debt outstanding and 5098 5145 5330 5452 5731 6223 6557

disbursed (TDO) (US$ millionsVa

Debt and debt service indicators

(%)TDO/XGSb 504.0 496.0 983.9 507.6 523.8 534.3 515.6

TDO/GDP 79.9 78.4 82.8 86.5 88.8 92.2 89.5

TDS/XGS 84.1 57.7 63.3 53.4 22.4 18.9 16.8

MBRD exposure indicators (%)IBRD DS/public DS 0.0 0.0 0.0 0.0 0.0 0.0 0.0

IBRD DS/XGS 0.0 0.0 0.0 0.0 0.0 0.0 0.0

IBRD TDO (US$ millions) 0 0 0 0 0 0 0

Of which present value of 0 0 0 0 0 0 0

guarantees (US$ millions)

Share of IBRD portfolio (%) 0 0 0 0 0 0 0

IDATDO(US$millions)c 1604 1586 1948 1759 2195 2657 2880

IFC (US$ millions)

Loans 0.00 0.00 5.00 0.00

EQuitv and ouasi_equitvd 0.00 0.00 3.57 0.00

MIGA

MIGA guarantees (US$ millions) 0.0 0.0 0.0 0.0

a. Includes ublic and vubliclv enaranteed debt pnvate noneuarantmd ux of IMF credits and net shoet-teert capita alter reschedutlin. Before 1999/00. after debt relief: thereaftet before debt relief

b. "XGS' denotes exports of goods and services, including workers' reamttances.c. Includes present value of guarantees.dk Irrelsdes equity and qeasi-equsiy types of bothi loan Tlnd equity itistesassents.Note: Seario assranes (i) HIPC decision point of September2001; (h) traditronal debt reliefonNapler terun dung tbe peiod; and(tii) at least comparabletreatrnent iv nor-Pasis Club

Source: Govenurarst of Ethiopia ard Staff eslirmates.

Annex F

Balance of Payments, 1997-2003Actual Fstimate Projected

Indicator 1997 1998 1999 2000 2001 2002 2003

Balance of Payments (US$ millions)Exports (goods andnonfactors services) 1011 1037 914 977 990 1059 1161

Merchandise FOB 599 602 484 489 476 529 600Coffee 355 420 281 253 209 234 270

Imports (goods and nonfactors services) 1589 1653 1873 2047 2046 2131 2241Merchandise FOB 1309 1357 1558 1735 1723 1787 187-7

Fuel 147 143 111 213 265 244 24(Resource balance -578 -616 -960 -1070 -1056 -1072 -1081

Trade balance -711 -755 -1074 -1246 -1247 -1258 -127'

Net income receipts -97 -66 -52 -68 -51 -38 -29Official interest payment 127 89 82 83 70 68 6S

Net current transfers 259 349 302 537 574 539 552Private transfers (net) 258 317 289 420 417 419 452

Current account balanceb -417 -333 -709 -601 -534 -571 -55"

Financing itemsOfficial capital grants 225 229 200 130 169 159 192Direct Investment 60 7 136 50 72 40 7(Loan Disbursements 210 159 215 163 521 597 434l

IDA exceptional financingc 0 0 0 0 269 329 15.~Repayments 744 509 496 450 140 117 11 :Otherd 510 425 634 502 12 33 2

Debt rescheduling 887 94 12 0 271 1 1New accuwulation of arrears 0 52 122 172 0 0 o

Change in reserves: 156 22 21 206 -100 -186 -125Central bank reservesf 306 171 -23 86 -87 -198 -137Fundcredit(net) 21 6 14 -11 32 12 12

Disbursements 21 6 14 0 45 27 27Commercialbanks(net)f -184 -136 36 148 -46 0 '1

Residual gapg 0 0 0 0 0 46 77

Memo;Official transfers (net) 226 261 213 247 325 279 2S 2CurTent accoulnt halance incl. official transfers -191 -104 -510 -471 -365 -412 l 365"GNFS" denotes 'goods and nonfactor services."

1, Includes net unrequited transfers excluding official capital grants.

Reconstrucion, Demobilization, Fertilizer Supplemental and POP Support.

I Includes debt relief and erors & ontissions

eIncludes use of IMF resources.

*Increase denoted by tmnus sign (-)

gGap can be filled through the Enhanced HIPC Initiative.

Note Scenario assumes (i) HIPC decisionpoint of Septetmber 2001; (ii) traditional debt reliefon Naples terms durin gtheperod, and (ui) at least comparable treatment by

non-Paris Club Creditors

Source Goveiment of Ethiopia and Staffestimates.

Annex G

Social Indicators

Latest single year Same region/income group

Sub- Saharan1970-75 1980-85 199399 Africa Low-income

POPULATIONTotal population, mid-year (millions) 33.0 43.4 62.8 627.3 3,536.4

Growth rate (% annual average) 2.6 2.8 2.3 2.2 1.4Urban population (% of population) 9.5 11.7 16.7 33.3 30.5Total fertility rate (births per woman) 5.8 7.0 6.4 5.4 3.1

POVERTY(% of population)National headcount index' ., 45.5

Urban headcount index .. ..

Rural headcount index .. ..

INCOMEGNP per capita (US$) .. 120 100 510 520Consumer price index (1995=100) 17 51 91 128 136Food price index (1995=100) .. 52 93

INCOME/CONSUMPTION DISTRIBUTIONGini index .. .. 40.0Lowest quintile (% of income or consumption) .. 8.6 7.1Highest quintile (% of income or consumption) .. 41.3 47.7

SOCIAL INDICATORS

Public expenditure

Health (% of GDP) .. .. 1.7 1.5 1.3Education (% of GNP) .. 3.0 4.0 4.1 3.2Social security and welfare (% of GDP) .. 1.4

Net primary school enrollment rate(% of age group)

Total .. 29 35 .. 86Male ,. 33 44 .. 89Female .. 25 27 .. 82

Access to safe water(% of population)

Total .. .. 30Urban .. .. 70Rural .. .. 28

Immunization rate(% under 12 months)

Measles .. 12 52 58 80DPT .. 6 63 53 82

Chid malnutrition (% under 5 years) .. ..

Life expectancy at birth(years)

Total 41 42 43 50 63Male 39 40 42 49 62Female 43 44 44 52 64

MortalityInfant (per thousand live births) 1 155 159 97 92 68Under 5 (per thousand live births)1 239 213 167 151 92

Adult (15-59)Male (per 1,000 population) 482 491 562 432 235Female (per 1,000 population) 411 401 529 383 208

Maternal (per 100,000 live births) 1 , .. 705

Most recent data from the Government of Ethiopia.

Source: Wodd Developmnent Indicators 2000 CD-ROM, World sank and I-PRSP 2000f01-2002/03, Government of Ethiopia.

Annex HPage 1 of 2

Status of Bank Group Operations(as of April 10, 2001)

I fifference Between

Expected andActual

Supervision Rating Original Amount in US$ DisbursementsMillions

Project Project Development Implementation Fiscal IIIRD IDA GRANT Cancel. Undisb. Orig. Frm Rev'dNumber Obiectives Proeress Year

P000733 AgricultureResearch&Train HS S 1998 0 60 0 0 42.9 6.5 0P000758 Calub Energy Development Project U U 1994 0 0 0 0 0 0 0P052315 Conservation ofMedicinal Plants # # 2001 0 26 0 0 2.6 0 0P073196 Demobilization and Reintegration Project # c 2001 0 170 6 0 0 160.6 18.7 0P000732 Education Sector Investment S U 1998 0 100 0 0 54.6 4.1 0P067084 Emergency Recovery and Rehabilitation # # 2001 0 230 0 0 207.4 0 0

ProjectP000736 EnergylI S S 1998 0 200 0 0 131 17.3 0P000771 Ethiopia Social RehabilitationFFund S S 1996 0 120 0 11.5 386 22.2 9P069886 Multisectoral HlV/AIDS Project S S 2001 0 59.7 0 0 50 1 -7 0P000756 Health Sector S U 1999 0 100 0 0 67.1 13.7 0P000753 National Fertilizer Project S S 1995 0 120 0 01 66 -23.2 0P000752 National Seeds Project S S 1995 0 22 0 0 9.7 5 0P000734 RoadRehabilitation S S 1993 0 96 0 0 25.3 1.9 0P000755 Road Sec. Dev. Program S S 1998 0 309.2 0 0 218.2 92.1 0P000764 WaterSupplyDevelopment& S S 1996 0 35.7 0 0 12.1 4.8 0

RehabilitationP050342 Women's Development Initiatives Project S S 2001 0 5 0 0 4.8 0.2 0

Total 0 8630.8 0 11.6 1031.5 134.9 9

1I3RD/IDA (as of April 10, 2001) Active Closed TotalProjects Projects

Total Disbursed 587.7 1687.9 2275 6of which has been repaid 0 314.20 314.20

Total Undisbursed 1,031.54 56 71 1088.25

Annex HPage 2 of 2

Status of IFC Operations(US$ millions)

Held Disbursed

FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic

Approvals Pending Commitment

Loan Equity Quasi Partic

1999 ShebaTannery 5 3.57 0 0

Total Pending Commitment: 5 3.57 0 0

Annex I

Portfolio Improvement and Project Implementation

1. The portfolio for Ethiopia consists of 15 projects, two of which, totaling US$467.90 million wereapproved in 2000/01. This year's lending alone is 45 percent of the $1 billion undisbursed balance. Therelatively young portfolio ($669 million approved in 1997/98) has recently undergone an extensive perlormancereview in October 2000. IDA's recent reengagement in substantial investment lending for reconstruction andrehabilitation will necessitate more rigorous monitoring of the portfolio. Even though the war has slowedimplementation, particularly disbursements over the last two and half years, only two projects are currently ratedunsatisfactory.

2. Portfolio Review: The Country Portfolio Performance Review (CPPR) carried out in Addis Ababaearlier this fiscal year discussed the weaknesses in portfolio implementation and made helpful recomme:ndationson portfolio improvement measures. The IDA disbursement ratio fell from 15 percent in 1998/99 (US$148million disbursed) to only 11 percent in 1999/2000 (US$105 million disbursed). However disbursements arepicking up and the ratio is almost 20 percent for 2000/01 as of April 1, 2001. In addition, the audit complianceratio fell from 24 percent in 1998/99 to 11 percent in 1999/2000. In some cases, the CPPR identified insufficientprogress on policy and institutional objectives. While low disbursements in 1999/2000 were due to th-te impactof the war and to slow international contractor mobilization on several large infrastructure projects, a morefundamental lack of public sector capacity are at the root of the poor performance - as shown by instances ofdisappointing project management, and weaknesses in procurement and financial management.

3. Portfolio Improvement Program: Following the CPPR, a Portfolio Improvement Program wasprepared and agreed with the MEDaC. Actions include the closing of a poorly-performing credit, preparation ofa Country Financial Accountability Assessment, tighter supervision of infrastructure contracts, and thestreamlining of planning and procurement under the Education and Health SDPs. Implementation of theprogram will be monitored by a joint IDA/Government team. Early signs are encouraging, with disbuirsementsfor 2000/01 up significantly from 11 percent in 1999/2000 to 20 percent in 2000/01. A Country ProcurementAssessment Report is also under preparation. Currently, 90 percent of the required audit reports are up to date.

4. Of the 14 projects in the portfolio only two (14 percent) are rated problem projects, the Educ.ation andHealth Sector Development Programs. A task force was set up to discuss implementation impediments. Thetask force has completed the review of SDPs in Education and Health. They are going to be reformulated duringnext fiscal year in line with PRSP priorities. A report was also submitted by the task force to the MolF withrecommendations on how to improve implementation bottlenecks at a regional level. In addition, a number ofregions had their own implementation workshops over the past months, and have invited the participation ofBank experts as resource persons.

5. Portfolio Reallocations: In preparing the emergency operations for reconstruction and demobilization,reallocations from the portfolio were made to support new activities. The Government had requested a totalreallocation of US$30 million consisting of US$17.5 million from the Social Rehabilitation Development Fund,US$9.8 million from Energy II, and US$2.5 million from the Multi-Sectoral HlV/AIDS program.

6. Over the next several months, IDA will work closely with the Government to strengthen its NationalCapacity Building Program and to help facilitate the smooth flow of funds to regional or decentralizedimplementing units. Improvements in the planning and approval processes at local levels combined withincreased harmonization of procurement and financial procedures will be critical for enabling the regions tomore efficiently implement projects.